Capital Expenditure Decisions
Presentation By : Sandip Gaudana
SGN
Structure
What is ‘Capital Expenditure’ Importance of Cap Ex Decisions Process Appraisal Methods
Non Discounting Discounting
What is Capital Expenditure ?
It is a Decision to invest
Current Funds into
Long Term Assets
In Anticipation of
Expected flow of benefits
Over a series of years.
Types of Cap Ex Decisions
Expansion of existing business
Expansion of new business
Replacement and modernisation
Importance
Growth Risk Funding Irreversibility Complexity
Process
Project Generation
Project Evaluation
Project Selection
Project Execution
Methods of Appraisal
Methods
Non Discounted Discounted
Pay Back Period
Accounting Rate of Return
Net Present Value
Internal Rate of Return
Profitability Index
Non Discounted Methods
Pay Back Period Accounting Rate of Return
Pay Back Period
Payback is the number of years required to recover the original cash outlay invested in a project.
0Initial InvestmentPayback = =
Annual Cash Inflow
C
C
Example : Equal Cash Flow Assume that a project requires an outlay of Rs
40,000 and yields annual cash inflow of Rs 10,000 for 7 years.
The payback period for the project is:
Payback = 40,000 = 4 Years
10,000
Example : Unequal Cash Flow
A project requires a cash outlay of Rs 20,000, and generates cash inflows of Rs 8,000; Rs 7,000; Rs 4,000; and Rs 3,000 during the next 4 years. What is the project’s payback?
3 Years + 12 * (1,000/3,000) Months 3 Years, 4 Months
Acceptance & Ranking
The project would be accepted if its payback period is less than the maximum or standard payback period set by management.
As a ranking method, it gives highest ranking to the project, which has the shortest payback period.
Some Aspects
Certain virtues: Simplicity Cost effective Short-term effects
Serious limitations: Cash flows after payback ignored Cash flow patterns Administrative difficulties
Accounting Rate of Return
The accounting rate of return is the ratio of the average after-tax profit divided by the average investment. The average investment would be equal to half of the original investment if it were depreciated constantly.
Average incomeARR =
Average investment
Example (Project Cost Rs. 40,000)
Year 1 2 3 4 5
EBDT 10,000 12,000 14,000 16,000 20,000
(-) Dep 8,000 8,000 8,000 8,000 8,000
EBT 2,000 4,000 6,000 8,000 12,000
(-) Tax 50% 1,000 2,000 3,000 4,000 6,000
PAT 1,000 2,000 3,000 4,000 6,000
Average = 3,200
BV (Beg) 40,000 32,000 24,000 16,000 8,000
BV (End) 32,000 24,000 16,000 8,000 ---
Average 36,000 28,000 20,000 12,000 4,000
Avg 20,000
ARR = 3,200 * 100 ARR = 16 %
20,000
Acceptance Rule
This method will accept all those projects whose ARR is higher than the minimum rate established.
This method would rank a project as number one if it has highest ARR.
Discounted Methods
Net Present Value Internal Rate of Return Profitability Index
Net Present Value
Net present value should be found out by subtracting present value of cash outflows from present value of cash inflows.
Steps Decide Appropriate rate for discounting Calculate Present Value of Cash Inflow NPV = PV of Cash inflows – PV of cash Outflow
Example
Project X costs Rs 2,500 now and is expected to generate year-end cash inflows of Rs 900, Rs 800, Rs 700, Rs 600 and Rs 500 in years 1 through 5. The opportunity cost of the capital may be assumed to be 10 per cent.
Example
2 3 4 5
1, 0.10 2, 0.10 3, 0.10
4, 0.10 5, 0.
Rs 900 Rs 800 Rs 700 Rs 600 Rs 500NPV Rs 2,500
(1+0.10) (1+0.10) (1+0.10) (1+0.10) (1+0.10)
NPV [Rs 900(PVF ) + Rs 800(PVF ) + Rs 700(PVF )
+ Rs 600(PVF ) + Rs 500(PVF
10)] Rs 2,500
NPV [Rs 900 0.909 + Rs 800 0.826 + Rs 700 0.751 + Rs 600 0.683
+ Rs 500 0.620] Rs 2,500
NPV Rs 2,725 Rs 2,500 = + Rs 225
Acceptance Rule
Accept the project when NPV is positive (NPV > 0) Reject the project when NPV is negative (NPV < 0) May accept the project when NPV is zero (NPV =
0)
The NPV method can be used to select between mutually exclusive projects; the one with the higher NPV should be selected.
Some Aspect
NPV is most acceptable investment rule for the following reasons: Time value Measure of true profitability
Limitations: Involved cash flow estimation Discount rate difficult to determine
Internal Rate of Return
The internal rate of return (IRR) is the rate that equates the investment outlay with the present value of cash inflow received after one period.
Internal Rate of Return is the discount rate which makes NPV = 0.
Calculation of IRR : Equal Cashflow
An investment cost Rs 6,000 and provide annual cash inflow of Rs 2,000 for 5 years.
Step : 1 Calculation of Factor
Factor = Original Investment (6,000) = 3
Avg. Cash flow per year (2,000) Referring to Annuity table for 5 years @ 18% ( Rs.
3.127) & @ 20 % ( Rs. 2.99)
Example (Continued)
1 2 3 4 3 6
Year Cash Inflow Disc. Fact @ 18%
(2 X3)PV of Inflow
Disc. Fact @ 20%
(2 X 5)PV of Inflow
1 2,000 0.847 1,694 0.833 1,666
2 2,000 0.717 1,436 0.694 1,388
3 2,000 0.609 1,218 0.579 1,158
4 2,000 0.516 1,032 0.482 964
5 2,000 0.437 874 0.402 804
Total 6,254 5.980
IRR = A + [(C- O)/(C-D)] * (B-A)
18 + [ (6,254 – 6,000) / (6254-5980)] * (20-18)
18 + ( 254 / 274) * 2
18 + 1.854
IRR = 19.854 %
Acceptance Rule
Accept the project when r > k. Reject the project when r < k. May accept the project when r = k.
Some Aspects
IRR method has following merits: Time value Profitability measure Acceptance rule
IRR method may suffer from: Tedious & Difficult to understand Mutually exclusive projects
Profitability Index
Profitability index is the ratio of the present value of cash inflows, at the required rate of return, to the initial cash outflow of the investment.
Example
An investment cost Rs 6,000 and provide annual cash inflow of Rs 2,000 for 5 years, consider discounting rate of 18 %
1 2 3 4
Year Cash Inflow
D F @ 18%
(2 X3)PV
1 2,000 0.847 1,694
2 2,000 0.717 1,436
3 2,000 0.609 1,218
4 2,000 0.516 1,032
5 2,000 0.437 874
Total 6,254
Profitabilty Index = PV of Cash Inflow
PV of investment
= 6,254 / 6,000
Profitability Index = 1.05
Acceptance Rule
The following are the PI acceptance rules: Accept the project when PI is greater than one.
PI > 1 Reject the project when PI is less than one.
PI < 1 May accept the project when PI is equal to one.
PI = 1 The project with positive NPV will have PI
greater than one. PI less than means that the project’s NPV is negative.
Some Aspects
Recognises the time value of money. A project with PI greater than one will have
positive NPV and if accepted, it will increase shareholders’ wealth.
Like NPV method, PI criterion also requires calculation of cash flows and estimate of the discount rate. In practice, estimation of cash flows and discount rate pose problems.
Which is more suitable ?
Observations…by authors
Most commonly used method for evaluating investment of small size is Pay Back Period
For some of the projects, ARR is used as principal method and Pay Back is supplementary.
Discounted Techniques are gaining importance in Large investments having substantial outlay.
Findings of a Survey
Survey by U Rao Cherukeri revealed the following
DCF methods have gained importance over a period of time ( Particularly the IRR)
ARR & PBP are widely used as supplementary evaluation methods.
WACC is commonly used as discount rate. Most often used in india is 15 %
Ranking in US
1. Internal Rate of Return (IRR)
2. Net Present Value (NPV)
3. Accounting Rate of Return (ARR)
4. Pay Back Period (PBP)
5. Profitability Index (PI)
?
Thank You !!!