Capital expenditures are those which:
Benefit future periods
Increase the serviceable life of the asset.
Increase the efficiency & productivity of the
asset.
Examples:
Land,building,machinery,furniture,vehicles,
expensive tools.
Capital Budgeting decisions is used to
evaluate investment decisions which
involve current outlays (or series of outlays)
but are likely to produce benefits over a
period of time longer than one year.
Peculiar features:
Large outlay with large anticipated return
Uncertainty – high degree of risk
Long time period between the initial outlay
& the anticipated return
Earning assets – generate finished goods to
be sold for profits
Covers long time span affecting company’s
future cost structure
Decision can not be reversed without heavy
financial loss
Large cash outlays involved ,hence wise
investment decision required for use of
scarce capital resources.
Identifying investment opportunities
Assembling of proposed investments
Decision making
Preparing capital budget and rationing
Implementing the capital expenditure plan
Performance review -feedback
Mandatory investments-Safety /Environmental
projects
Replacement of assets
Expansion of present capacity
Diversification projects
Mergers and Acquisitions
Estimate the future incremental after-tax
cash flows from the proposed investment .
Deciding the selection criterion e.g.required
rate of return on investment.(Cost of capital
or hurdle rate)
Application of the decision rule for making
the investment choice
Traditional tools(Non-Discounting criteria):
Payback Method
Discounted payback
Accounting rate of return
Discounted cash flow techniques:
Net Present Value (NPV)
Profitability index
Internal Rate of Return (IRR)
Modified Internal Rate of Return (MIRR)
Number of years required for recovering
initial investment in the project is known as
the pay-back period.
Shorter the payback period ,better is the
project
Firms usually specify the maximum
acceptable pay-back period ,for independent
projects
Initial investment of Rs.8,000,life of the asset
= 4 years
Expected cash inflows :
Rs.3000,Rs.3500,Rs.2500,Rs.3600.
Pros:
Simple to understand and use
Cost effective
Insight into liquidity and minimising risk
Cons:
Cash flows after the PB period not
considered
Ignores time value of money
Not consistent with shareholder value
maximisation objecive.
ARR is calculated in different ways.The most
common ways are:
ARR = Average annual after-tax profits
Average book value of investment
Decision rule: accept the projects with ARR
higher than minimum rate established by the
management
Initial investment : Rs.80,000
Earnings for 5 years (EBIT) :
Year 1 : Rs.20,000
Year 2 : Rs.24,000
Year 3 : Rs.30,000
Year 4 : Rs.32,000
Year 5 : Rs.36,000
Tax rate : 30 %
Pros:
Simple to use
Prepared from accounting data
Cons:
Does not consider cash flows
Time value of money ignored
Arbitrary cut-off rate
NPV= Present Value of future cash inflows – Investment
Process :
◦ Capture the relevant Cash Flows.
◦ Discount the Cash Flows to arrive at Present Value of the Cash
Flows.
◦ Deduct the Investment from the PV to arrive using an
appropriate discount rate
Discount rate is the cost of capital invested in the proposed
investment being evaluated.
Decision Rule:
Accept the project if it gives positive NPV
Select the project with higher NPV
Initial Investment :
Cost of fixed asset 300 L
Invt in W.C. = 50 L
Cash flows (FCF) =
Year 1 = 100L,
Year 2 = 150L,
Year 3 = 250L
Discounting rate = 10 %
CF 0(today) CF1(Rs.L) CF2(Rs.L) CF3(Rs.L)
(Rs.L)
-350 100 150 250
PV factor 1/(1.1) 1/(1.1)^2 1/(1.1)^3
Discounted 90.9 123.9 187.75
cash flows
PV of cash 402.55
inflows
NPV 52.55L
It is the ratio of PV of Inflow to the PV of the
Investment
PV of Cash inflows / PV of Out flows
3.Decision Rule:
If ratio > 1 then accept the investment
Select the project with higher profitability
index.
The IRR of a project is the discount rate at
which the NPV of the project is zero.
Process:
1.Capture the relevant cash flows
2.Using trial & error method find out the
discount rate at which
NPV = 0
3.Decision Rule:
If the discount rate i.e. IRR is greater than the
opportunity cost of Capital. Accept the project
Select the project with higher IRR
1.Determine the pay back period by dividing
the initial investment by average cash flow
after taxes
2.Look for the factor closest to the pay back
period in the annuity table for the life
period for the project.The interest rate
obtained is the rough approximation of IRR.
3.Make adjustments to the rate depending on
the pattern of mixed stream of cash flows
e.g. if the initial period CFAT are higher
than average then the IRR would be
adjusted upwards and vice-versa.
NPV is in Rupee terms whereas IRR is in
percentage terms,hence practically IRR is
more popular as it is better understood , even
by a non-finance person.
NPV and IRR would lead to the same decision
when…
The cash-flows follow conventional patterns
Evaluation of independent projects
Companies use multiple evaluation methods
in investment analysis
IRR is the most popular evaluation method
For 2 or more mutually exclusive
projects,NPV is used
Payback and ARR methods are also used as
supplementary methods,especially in small
sized projects.
The discounting rate is the weighted
average cost of capital applicable based on
the risk involved.
Estimation of future cash inflows/outflows is
the first step in investment analysis of any
project.
The relevant cash flows to be considered for
capital investment decisions are based on
certain basic principles…
Conventionally cash flows of a new project
would involve:
1. Initial Investment which includes :
Capital expenditure on procuring fixed
assets
Net working capital requirement
2. Operating cash inflows/outflows and
3. Terminal cash flows which include:
Salvage value of the new asset(After tax) and
Recovery of net working capital invested
1. Initial Investment which includes :
Capital expenditure on procuring new fixed asset less the
proceeds from the sale of the old asset
Net additional working capital required by the new asset as
compared to the old asset
2. Additional after tax operating cash inflows/outflows
expected from the new investment i.e. :
(Incremental operating profit before depreciation
Less: Incremental depreciation) * (1-t)
+ Incremental depreciation
3. Difference in the terminal cash flows which include:
Salvage value of the new asset – salvage value of the old
asset(After tax )
Recovery of additional net working capital invested in the
new asset
Mutually exclusive projects which have
unequal lives and are repeatable can not be
compared on the basis of their respective
NPV
2 approaches used for comparison /selection
are :
(a)Replacement chain approach
(b)Equivalent Annual Value (EAV)
A B
Initial Investment 20000 35000
Life 3 years 6 years
Cash flows :
Year 1 8000 8000
Year 2 10000 8000
Year 3 10000 9000
9000
10000
10000
Cost of Capital is 10 %
In this approach NPV needs to be calculated for
‘common period’ for the 2 projects being
compared.
This may involve repeating the investment for
a project with a shorter life multiple times to
match the common life.
E.g. if Project A and B has life of 3 years and 6
years respectively, investment in Project A will
be twice , in the beginning and after 3 years ,
to match the common period of 6 years.
In this approach ,the NPV of the mutually
exclusive projects (with unequal lives) is
calculated .
Each NPV is then converted into EAV by
applying annuity factor based on the life of
the respective project.
The project giving highest EAV (NPV) would
be selected.
M/C Alpha M/C Beta
Initial investment 40 L 30 L
Average annual 4L 5L
operating costs
Project life 6 years 4 years
Cost of capital 12 % 12 %
Annuity factor 6 years - 4.111 4 years – 3.037
@12 % :
