Concept Note on Basics of Capital Expenditure Decisions Prof.

Bhavana Raj CAPITAL EXPENDITURES & THEIR IMPORTANCE: The basic characteristics of a capital expenditure (also referred to as a capital investment or just project) is that it involves a current outlay (or current & future outlays) of funds in the expectation of receiving a stream of benefits in future. Importance stems from: (1)Long-term consequences (2)Substantial outlays & (3) Difficulty in reversing. CAPITAL BUDGETING PROCESS: Capital budgeting is a complex process which may be divided into the following phases: (1)Identification of Potential Investment Opportunities: The capital budgeting process begins with the identification of potential investment opportunities. Typically, the planning body (it may be an individual or a committee organized formally or informally) develops estimates of future sales which serve as the basis for setting production targets. This information, in turn, is helpful in identifying required investments in plants & equipment. Identification of investment ideas is helpful to (a) monitor external environment regularly to scout investment opportunities, (b) formulate a well defined corporate strategy based on a thorough analysis of strengths, weaknesses , opportunities & threats, (c) share corporate strategy & perspectives with persons who are involved in the process of capital budgeting, &(d) motivate employees to make suggestions. (2)Assembling of Investment Proposals : Investment proposals identified by the production department & other departments are usually submitted in a standardized capital investment proposal firm. Generally, most of the proposals ,before they reach the capital budgeting committee or somebody which assembles them, are routed through several persons. The purpose of routing a proposal through several persons is primarily to ensure that the proposal is viewed from different angles. It also helps in creating a climate for bringing about co-ordination of interrelated activities. Investment proposals are usually classified into various categories for facilitating decision making, budgeting and control. For example: (a)Replacement investments, (b) Expansion investments, (c) New product investments and (d) Obligatory and welfare investments. (3)Decision Making: A system of rupee gateways usually characterizes capital investment decision making. Under this system, executives are vested with the power to okay investment proposals up to certain limits. For example, in one company the plant superintendent can okay investment outlays up to Rs 200,000, the works manager up to Rs 500,000, & the managing director up to Rs 2,000,000.Investments requiring higher outlays need the approval of the board of directors. (4)Preparation of Capital Budget & Appropriations: Projects involving smaller outlays & which can be decided by executives at lower levels are often covered by a blanket appropriation for expenditure action. Projects involving larger outlays are included in the capital budget after necessary approvals. Before undertaking such projects an appropriation order is usually required. The purpose of this check is mainly to ensure that the funds position of the firm is

Hence firms normally classify projects into different categories. (1)Mandatory Investments: These are expenditures required to comply with statutory requirements. crèche in factory premises & so on. (5)Implementation: Translating an investment proposal into a concrete project is a complex. Certain projects. . medical dispensary. (b)Use of the principle of responsibility accounting: Assigning specific responsibilities to project managers for completing the project within the defined time-frame and cost limits is helpful for expeditious execution & cost control. Further. (c) Use of network techniques: For project planning & control. It is useful in several ways : (a)it throws light on how realistic were the assumptions underlying the project. For expeditious implementation at a reasonable cost. In analyzing such investments. (6)Performance Review: Performance review or post-completion audit is a feedback device. These are often non-revenue producing investments. several network techniques like PERT (Programme Evaluation Review Technique) & CPM (Critical Path Method) are available. can lead to substantial cost-overruns. (b) it provides a documented log of experience that is highly valuable for decision-making. though at times the analysis may ne quite detailed. Put differently. many surprises & shocks are likely to spring on the way. it provides an opportunity to review the project at the time of implementation. raw material & power). Delays in implementation . (2)Replacement Projects: Firms routinely invest in equipments meant to replace obsolete & inefficient equipments. when the operations of the project have stabilized. even though they may be in a serviceable condition. the following categories are found in most classifications. With the help of these techniques. PROJECT CLASSIFICATION: Project analysis entails time & effort. time-consuming & risk-fraught task. (c) it helps in uncovering judgmental biases & (d) it induces a desired caution among project sponsors. may warrant a detailed analysis. Hence. It is a means for comparing actual performance with projected performance . Replacement projects can be evaluated in a fairly straightforward manner.It may be conducted . The objective of such investments is to reduce costs (of labor.satisfactory at the time of implantation. given their complexity and magnitude. the focus is mainly on finding the most costeffective way of fulfilling a given statutory need. While the system of classification may vary from one firm to another. others may call for a relatively simple analysis. if necessary homework in terms of preliminary studies & comprehensive & detailed formulation of the project is not done. monitoring becomes easier. the need for adequate formulation of the project cannot be over-emphasized. most appropriately. the following are helpful. which are common. fire fighting equipment. The costs incurred in this exercise must be justified by the benefits from it. increase yield & improve quality. (a)Adequate formulation of projects: The major reason for delay is inadequate formulation of projects. Each category is then analyzed somewhat differently. Examples of such investments are pollution control equipment.

however. R&D projects absorbed a very small proportion of capital budget in most Indian companies. INVESTMENT CRITERIA: A wide range of criteria has been suggested to judge the worthwhileness of investment projects. expansion projects normally warrant more careful analysis than replacement projects. Since this can be risky & complex. they require a significant involvement of the board of directors. Further. both quantitative & qualitative. Firms which rely more on quantitative methods use decision tree analysis & option analysis to evaluate R&D projects. . executive aircrafts. Things. more so in knowledge-intensive industries. Such projects are decided on the basis of managerial judgment. landscaped gardens & so on. Such investments call for an explicit forecast of growth. Decisions relating to such projects are taken by the top management. Companies are now allocating more funds to R&D projects. are changing. (6)Miscellaneous Project: This is a catch-all category that includes items like interior decoration. Given their strategic importance . recreational facilities. & require considerable managerial effort & attention. such projects call for a very thorough evaluation. There is no standard approach for evaluating these projects & decisions regarding them are based on personal preferences of top management.(3)Expansion Projects: These investments are meant to increase capacity &/or widen the distribution network. involve large outlays. Often diversification projects entail substantial risks. (5)Research & Development Projects :Traditionally. Hence the standard DCF(Discounted Cash Flow) analysis is not applicable to them. R&D projects are characterized by numerous uncertainties & typically involve sequential decision-making. (4)Diversification Projects: These investments are aimed at producing new products or services or entering into entirely new geographical areas.

(1)NET PRESENT VALUE (NPV): The NPV of a project is the sum of the present values of all cash flows-positive as well as negative-that are expected to occur over the life of the project. Even if the new projects taken on by TCS have positive NPV. . negative. they can be added. When a firm takes on a new project with a positive NPV.TCS. Two projects A & B’s net present value of the combined investment is : NPV(A+B)=NPV(A)+NPV(B). If the price is greater/lesser than the PV of the anticipated cash flows of the project the value of the firm will increase/decrease with the divesture. (2)INTERMEDIATE CASH FLOWS ARE INVESTED AT COST OF CAPITAL: The NPV rule assumes that the intermediate cash flows of a project. i. n=life of the project. cash flows that occur between the initiation & the termination of the project are reinvested at a rate of return equal to the cost of capital. when a firm undertakes a new project that has a negative NPV. The cost of capital must reflect the risk of the project. the price at which the project is divested affects the value of the firm. for example. Likewise. is expected to take on high positive NPV projects & this expectation is reflected in its value. the value of the firm increases by that amount. PROPERTIES OF THE NPV RULE: (1)NPVs ARE ADDITIVE: Since the PV’s are measured in today’s rupees.. Decision rule of NPV criterion: Accept the Project Reject the Project Indifference or Project Doesn’t matter If the NPV is If the NPV is If NPV is Zero. This property has several implications: The value of a firm can be expressed as the sum of the PV of projects in place as well as the NPV of prospective projects: Value of a firm=Σ(PV of projects)+ Σ(NPV of expected future projects). The NPV represents the net benefit over & above the compensation for time & risk. its effect on the value of the firm depends on whether its NPV is in line with expectation. the value of the firm may drop if the NPV is not in line with the high expectations of the investors. The first term on the RHS side of the equation captures the value of assets in place & the LHS captures the value of growth opportunities.When a firm terminates an existing projects which has a negative NPV based on its expected future cash flows. NPV of Project=∑(t=1 to n) {[Ct]/[(1+r)^t]}-[Initial Investment]. The cash flows are discounted at an appropriate discount rate (cost of capital. When a firm divests itself of an existing project .When a firm makes an acquisition & pays a price in excess of the PV of the expected cash flows from the acquisition it is like taking on a negative NPV project & hence will diminish the value of the firm.e. the value of the firm decreases by that amount.The NPV of a package of projects is simply the sum of the NPV’s of individual projects included in the package. r=discount rate. positive. where Ct=cash flow at the end of year ‘t’.

(3)NPV CALCULATION PERMITS TIME-VARYING DISCOUNT RATES: So far we assumed that the discount rate remains constant over time. (4)NPV OF A SIMPLE PROJECT AS THE DISCOUNT RATE. causing changes in the cost of capital. Put differently. (3)INTERNAL RATE OF RETURN (IRR). it is the discount rate which equates the PV of future cash flows with the initial investment. Pros Cons (1) Reflects the time value (1) Is an absolute measure and not a relative of money. the BCR criterion is unsuitable as a selection criterion. Investment=Σ(t=1 to n) {[Ct]/[(1+r)^t]}. The validity of the argument is : (a)Under unconstrained conditions. (b) When the capital budget is limited in the current period. it can discriminate better between large & small investments & hence is preferable to the NPV criterion.e. in its entirety. measure. (3) Squares with the (3)When mutually exclusive projects with objective of wealth different lives are being considered.. The discount rate may change over time for the following reasons : (a) The level of interest rates may change over time i.r: The IRR of a project is the discount rate which makes its NPV equal to zero. (2)BENEFIT COST RATIO (BCR): There are 2 ways of defining the relationship between benefits & costs. (b) The risk characterizes of the project may change over time. (a) BCR=[PVB]/[I] & (b) Net BCR= {[PVB-I]/[I]} or NCBR =[BCR-1]. Pros (1) Measures bang per buck. the BCR criterion may rank projects correctly in the order of decreasingly efficient use of capital. where. (c) The financing mix of the project may vary over time. Decision rule of BCR criterion: If BCR or If NBCR Rule is >1 >0 Accept =1 =0 Indifferent <1 <0 Reject Evaluation: The proponents of BC ratio argue that since this criterion measures NPV per rupee outlay. where. (c) When cash outflows occur beyond the current period. the tern structure of interest rates sheds light on expected rates in future. the BCR criterion will accept & reject the same projects as the NPV criterion. . This need not be always the case. its use is not recommended because it provides no means for aggregating several smaller projects into a package that can be compared with a larger project. (2) Considers the cash flow (2)Doesn’t consider the life of the project. Cons (1) Provides no means for aggregation. rule is biased in favor of the longer term period. the NPV maximization. However. PVB = present value of benefits & I = initial investment. The NPV can be calculated using time-varying discount rates. resulting in changes in the cost of capital.

(2)Calculates the NPV . (2)MUTUALLY EXCLUSIVE PROJECTS (3)LENDING VS. we set the NPV equal to zero & determine the discount rate that satisfies the condition. (4)MODIFIED INTERNAL RATE OF RETURN (MIRR):Despite NPV’s conceptual superiority. using cost of capital (r) as the discount rate: PVC = Σ (t=0 to n) {[Cash outflow (t)]/ [(1+r)^t]}. MIRR is a percentage measure that overcomes the shortcomings of the regular IRR.Ct= cash flow at the end of year ‘t’. Decision rule of IRR criterion: Accept: If the IRR is greater than the cost of capital. Evaluation: MIRR is superior to the regular IRR in two ways. Step 3: Obtain MIRR by solving the following equation: PVC=[TV/[(1+MIRR)^n]]. IRR (1)Assumes that the Net NPV=0. The procedure for calculating MIRR is as follows: Step 1: Calculate the PV of the costs (PVC) associated with the project. r=internal rate of return (IRR) & n=life of the project. In the IRR calculation. Cons (1) May lead to multiple rates of return. NPV Vs IRR: NPV (1)Assumes that the discount rate (cost of capital) is known. MIRR assumes that project cash flows are reinvested at the cost of capital whereas the regular . Pros (1) Closely related to NPV. Step 2: Calculate the terminal value (TV) of the cash inflows expected from the project: TV= Σ (t=0 to n) {[Cash inflow (t)] * [(1+r)^(n-t)]}. First. In the NPV calculation we assume that the discount rate (cost of capital) is known & determine the NPV. managers seem to prefer IRR over NPV because IRR is intuitively more appealing as it is a percentage measure. BORROWING & (4)DIFFERENCES BETWEEN SHORT-TERM AND LONG-TERM INTEREST RATES. PROBLEMS WITH IRR: (1)NON-CONVENTIONAL CASH FLOWS. given the discount rate. (2)May result into incorrect decisions in comparing mutually exclusive projects. (2)Figures out the discount rate that makes the NPV=0. Reject: If the IRR is less than the cost of capital. (2)Easy to understand & interpret.

Evaluation: Advantages: (1)It is simple. When the annual cash inflow is a constant sum. MIRR reflects better the true profitability of a project. Thus. (2)It is a rough & ready method for dealing with risk. Since reinvestment at cost of capital ( or some other explicit rate) is more realistic than reinvestment at IRR. (2)It ignores cash flows beyond the payback period.IRR assumes that project cash flows are reinvested at the project’s own IRR. consider the cash flows of two projects. This violates the most basic principle of financial analysis which stipulates that cash flows occurring at different points of time can be added or subtracted only after suitable compounding or discounting. Is it as good as NPV in choosing between mutually exclusive projects?: (a)If the mutually exclusive projects are of the same size. projects with a payback period of n years or less are deemed worthwhile & projects with a payback period exceeding n years are considered unworthy. in general. The shorter the payback period Firms using this criterion generally specify the maximum acceptable payback period. It favors projects which generate substantial cash inflows in earlier years & discriminates against projects which bring substantial cash inflows in later years but not in earlier years. However. Now. Verdict: MIRR is better than the regular IRR in measuring true rate of return. MIRR is a distinct improvement over the regular IRR. if risk tends to increase with futurity. in the payback calculation. If this is ‘n’ years. It doesn’t use involved concepts & tedious calculations & has few hidden assumptions. NPV & MIRR lead to the same decision irrespective of variations in life. For example. Decision rule of Payback criterion: The more desirable the project. (5)PAYBACK PERIOD (PBP): The Payback period is the length of time required to recover the initial outlay on the project. the payback period =[Initial Outlay /Annual Cash Inflow]. A & B: Year Cash Flow of A Cash Flow of B . the payback criterion may be helpful in weeding out risky projects. Second. for choosing among mutually exclusive projects of different size. This leads to discrimination against projects which generate substantial cash inflows in later years. the problem of multiple rates doesn’t exist with MIRR. this may be true. (3)Since it emphasizes earlier cash inflows. it may be a sensible criterion when the firm is pressed with problems of liquidity. NPV is a better alternative in measuring the contribution of each project to the value of the firm. Cash inflows. are simply added without suitable discounting. (b)If the mutually exclusive projects differ in size there is a possibility of conflict. Limitations: (1) It fails to consider the time value of money. both in concept & application.

(4)It serves as a useful shortcut in the process of information generation & evaluation.000 20. C=constant annual cash flow. (6)Discounted Payback period (DPBP): A major shortcoming of the conventional payback period is that it doesn’t take into account the time value of money . (3)The payback period is somewhat similar to the break-even point.& modify/change other investment decisions. (b)When ‘n’ is very large. (5)The payback period conveys information about the rate at which the uncertainty associated with a project is resolved. (4)Though it measures a project’s liquidity. Reasons for popularity of Payback Period: (1)Despite the shortcomings the payback period is widely used in appraising investments as the payback measure serves as a proxy for certain types of information which are useful in investment decision-making.000 20.000 4 10. the internal rate of return is approximately the inverse of the payback period. which is more important. not profitability.000 50. Decision rule of Discounted Payback criterion: The shorter the payback The faster the uncertainty associated with the project is resolved. The internal rate of return is the value of ‘r’ in the equation: (a)I=∑(t=1 to n) [C/[(1+r)^t]] + [S/[(1+r)^n]].000 40.000) 1 50. r = [C/I]. . adjust his consumption patterns.In other words.000 20. cash flows are first converted into their PVs(by applying suitable discounting factors) & then added to ascertain the period of time required to recover the initial outlay on the project. S=Salvage value & n=life of the project. I=[C/r]Therefore.0 Rs (100. (3)It is a measure of project’s capital recovery. (2)The payback period may be regarded roughly as the reciprocal for the internal rate of return when the annual cash inflow is constant & the life of the project is fairly long.000 6 60. even though B has very substantial cash inflows in years 5 & 6. which has a payback period of 3 years in comparison to B which has a payback period of 4 years. This enables the decision-maker to take prompt corrective action. it doesn’t indicate the liquidity position of the firm as a whole. I=initial outlay.In discounted payback period.000 The payback criterion prefers A. period Note: Decision-makers prefer an early resolution of uncertainty.000 5 10. period The longer the payback The slower the uncertainty associated with the project is resolved.000 3 20. where.000 2 30.000) Rs (100.

The lower the ARR  Note: In general. Evaluation: Pros Cons (1)Simple. if ever. (1)Does not take into account the TVM. discounted cash flow methods have gained in importance and internal rate of return is the most popular evaluation method. INVESTMENT APPRAISAL IN PRACTICE: (1)Over time. (2)Firms typically use multiple evaluation methods. (2)Considers (2) Based on accounting profit. (3)Accounting rate of return and payback period are widely employed as supplementary evaluation methods. The higher the ARR  The worse the project. While accounting the numerator represents profit belonging to equity & information which is preference stockholders. businessmen. (3)Based on (23) The ARR measure is internally inconsistent.(7)ACCOUNTING RATE OF RETURN (ARR): also called the AVERAGE RATE OF RETURN: {[PAT or Profit After Tax]/[Book Value of the Investment]}. equal to the familiar to contribution of equity & preference stockholders. . (a)The numerator of this ratio may be measured as the average annual post-tax profit over the life of the investment & (b) the denominator is the average book value of fixed assets committed to the project. benefits over the entire project life. the denominator represents readily available & fixed investment which is rarely. others are rejected. projects which an ARR equal to or greater than a pre-specified cut-off rate of return which is usually between 10% & 30% are accepted. Decision rule of ACCOUNTING RATE OF RETURN (ARR) or AVERAGE RATE OF RETURN: The better the project. not cash flow.

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