Understanding Investmentin

Long Term Assets

- A Practical Approach

Drucker… The guru….

"Until a business returns a profit that is greaterthan its cost of capital, it operates at a loss.Never mind that it pays taxes as if it had agenuine profit. The enterprise still returnsless to the economy than it devours inresources…Until then it does not createwealth; it destroys it."

Some “home truths” about Capex

• Good investment projects do not simply

emerge out of woodwork - they have to be

identified, defined and revised

• Non-quantifiable aspects frequently have a

significant impact on the decision outcome

• Estimates are rarely free from bias

• “The child that cries loudest normally gets

the chocolate”

Investment Proposals

CapexAppraisalFilter

Factory/Branch Level

InvestmentProposals

DivisionalLevel

DivisionalLevel

InvestmentProposals

Top ManagementLevel

Investments Selected

Approval of Capex ProposalAppraisal of Capex Proposal

Origination of Capex Proposal

Process of Capex Budgeting

• Generation of Proposals

• Categorisation of proposals

• Evaluation /Screening

• Selection of Proposals

• Compilation of Departmental Proposals

• Compilation of preliminary Budget

• Departmental Reviews/Feedback

• Budget Proposal

• Finance Review/Financing Plan

• Budget Document for Approval

• Board Review - comments

• Approved Capital Budget Document

• Incorporation in Business Plan

Classification by Needs

• Cost Reduction– Modernisation– Upgradation– Process Improvements

• Revenue Generation– Expansion– Diversification

• Operational Necessity– Reconstruction– Replacement– Risk Reduction

• Statutory/Societal compulsions

Cost numbers for Capex

• Relevant & Irrelevant Costs

• Avoidable & Unavoidable Costs

• Sunk Costs & Opportunity Costs

• Apportioned Costs

• Marginal & Incremental Costs

Relevant Information for Decision Making

Is it

Futuristic?

Does it

vary with

alternative?

Yes

No

Yes

No

Irrelevant for Decision Making

Relevant

for

Decision

Making

Relevant

information

is futuristic& it varies

with alternative

Case: Choice between the alternatives

- Total Cost Approach

Main frame

Work

station Difference

Revenue 30,000,000 30,000,000 -

Operating Costs:

Non-computer related operating costs 26,400,000 26,400,000 -

Computer related cash operating costs 1,200,000 300,000 900,000

Mainframe book value

Periodic write-off as depreciation 1,800,000 -

Or Lumpsum write-off - 1,800,000 -

Current disposal value - (950,000) 950,000

Workstations, written off as depr. - 1,350,000 (1,350,000)

Total operating costs 29,400,000 28,900,000

Operating Income 600,000 1,100,000 500,000

Three years together

Case: Choice between the alternatives

- Relevant Cost Approach

Main frame

Work

station Difference

Computer related cash operating costs 1,200,000 300,000 900,000

Current disposal value - (950,000) 950,000

Workstations, written off as depr. - 1,350,000 (1,350,000)

Total Relevant Costs 1,200,000 700,000 500,000

Three years together

Rajesh Pande’s reluctance…

In the first year Keep Main

frame

Buy Work

station

Revenue 10,000,000 10,000,000

Operating Costs:

Non-computer related operating

costs8,800,000 8,800,000

Computer related cash operating

costs400,000 100,000

Depreciation 600,000 450,000

Loss on sale of Main-frame - 850,000

Total operating costs 9,800,000 10,200,000

Operating Income 200,000 (200,000)

People behave in the way their

performance is measured

Financial Evaluation - Basics

• Cost numbers for Capex

• Cash flows

• Time Value of Money

• Cost of Capital

• Appraisal Criteria

• Risk

Cash Flows

• Initial investment

– Cost of capital assets

– Installation costs

– Working Capital Margin

– Other startup expenses

Cash Flows

• Operating Cash Flows

– Profit after Tax + Depreciation + Other non-cash charges + Interest on long term debt(1-tax rate)

• Terminal Cash flows

– Post-Tax proceeds from the sale of capital assets + Net recovery of Working capital margin

Biases in Cash Flow Estimates

• Overstatement of Profitability– Intentional Overstatement

– Lack of Experience

– Myopic Euphoria

– Capital Rationing

– Splitting the Proposal

• Understatement of Profitability– Salvage values are under-estimated

– Intangible benefits are ignored

RepairCost

Total Cost Visibility- The Iceberg Effect

TrainingCost

SpecialtiesEquipment

Cost

FacilitiesCost

SupplySupport

Cost

Retirement& Disposal

Cost

TechnicalDataCost

Transportation& Handling

Cost

PoorManagement

AcquisitionCost