Chapter

 12  –  Capital  Expenditure  Decisions  

What  is  capital  expenditure,  what  are  the  4  steps  of  a  capital  expenditure  decisions?  
-­‐ capital  expenditure  decision  -­‐  long-­‐term  decision  where  business  determines  
whether  or  not  to  make  an  investment  at  the  time  in  order  to  obtain  future  
net  cash  receipts  that’ll  exceed  the  investment  (positive  ROI)  
-­‐ 3  categories  of  investment  alternatives:  new  investments  (increase  revenue);  
new  technology  (save  costs);  replacement  of  old  assets  as  they  wear  out  
-­‐ risks  of  investment:  involve  large  amounts  of  resources,  uncertainty,  difficult  
to  reverse,  span  over  long  periods  of  time  
-­‐ general  rule:  capital  expenditure  proposal  is  acceptable  when  return  on  
investment  is  greater  than  cost  of  providing  the  cash  to  make  the  investment  
-­‐ Steps  in  making  a  capital  expenditure  decision:  
 
What  does  a  business  include  in  the  initial  cost  of  a  
capital  expenditure  proposal?  
Estimating  the  initial  cash  payment  
-­‐ initial  cost-­‐expected  cash  payment  to  be  made  to  put  proposal  into  operation  
-­‐ sometimes,  the  proposal  requires  investment  of  additional  working  capital  
-­‐ initial  costs  may  involve  the  use  of  estimates  (e.g.  quotes  from  contractors)  
Estimating  future  cash  flows  
-­‐ expected  future  net  cash  receipts  help  to  provide  ROI  
-­‐ 3  forms  of  net  future  cash  receipts:    
1) future  cash  receipts  only  (e.g.  no  future  outflows-­‐dividends)  
2) future  cash  receipts  exceed  future  cash  payments,  positive  net  cash  inflow  
3) savings  of  future  cash  payments,  reduction  in  future  cash  outflow  (no  cash  
inflow)  (e.g.  upgrading  to  more  fuel  efficient  and  saving  fuel  costs  in  future)  
 
What  are  the  relevant  costs  of  a  capital  expenditure  proposal  and  how  do  operating  
income,  depreciation  and  ending  cash  flows  affect  these  costs?  
-­‐ relevant  cash  flows:  future  cash  flows  that  differ  in  amount  or  in  timing  as  a  
result  of  accepting  a  capital  expenditure  proposal;  relevant  as  it  affects  
business’  long-­‐term  profitability  
-­‐ relevant  cash  flows  are:  the  expected  additional  future  cash  flows;  expected  
savings  in  future  payments  
-­‐ deciding  which  cash  flows  are  relevant  for  the  decision  is  similar  to  deciding  
what  costs  are  relevant  for  a  short-­‐term  decision  
-­‐ to  be  relevant  to  a  particular  capital  expenditure  decision,  cash  flows  must:  
o occur  in  the  future  
o result  from  activities  that  are  required  by  the  proposal  
o cause  a  change  in  the  business’  existing  cash  flows  
Operating  income,  depreciation  and  ending  cash  flows  
-­‐ most  revenues  &  expenses  result  in  cash  in  &  outflows  approx.  at  same  time  
-­‐ expected  future  operating  revenues&expenses  are  frequently  used  as  
estimates  for  relevant  future  cash  inflows  and  outflows  
-­‐ depreciation  expenses  are  not  cash  flows  
-­‐ but  acquisition  cost(of  investment)  is  a  cash  outflow  and  the  scrap  amount  (if  
any)  is  a  future  cash  inflow  
  
How  does  a  business  determine  the  rate  of  return  it  requires  on  a  capital  
expenditure  proposal?  
Determining  the  required  return  on  investment  
-­‐ required  return=cost  of  providing  cash  for  investment  (expressed  as  %)  
-­‐ business’  financial  position  improves  if  accepting  capital  expenditure  
proposal  provides  a  return  that’s  higher  than  cost  of  the  investment  
-­‐ cost  of  capital-­‐rate  that  measures  cost  of  providing  cash  for  investment  
-­‐ capital  comes  from  interest,  dividends,  etc.  each  source  demands  ROI  
-­‐ cost  of  capital  is  the  weighted-­‐average  cost  it  must  pay  to  sources  of  capital  
-­‐ cost  of  capital  is  the  cut-­‐off  rate  used  to  distinguish  between  
acceptable&unacceptable  capital  expenditure  proposals;  to  be  acceptable:  
return  on  proposal  must  be  equal/greater  than  business’  cost  of  capital  
-­‐ consistent  cost  of  capital  rate  must  be  used  for  evaluating  proposals  
Determining  acceptable  capital  expenditure  proposals  
-­‐ business  may  use  different  methods  to  analyse  whether  a  capital  expenditure  
proposal  is  acceptable  (e.g:  NPV  method;  payback  method;  accg  rate  of  
return  method)  
Time  value  of  money  and  present  value  (ACST)  
-­‐ time-­‐value  of  money  –$1  in  the  future  is  worth  less  than  $1  now  
-­‐ FV=PV(1+i)n    (e.g.  FV=100  (1+0.04)1  =  $104)  
!"#
-­‐ To  find  present  value:  rearrange  future  value  formula;  PV  =  (!.!")! = $100  
-­‐ Present  value=today’s  value  of  $  amount  received  in  the  future  
-­‐ Use  1st  table  for  compound  (single  payment)  
-­‐ Use  2nd  table  for  annuity  (multiple  payments)  
 
How  does  a  business  use  the  net  present  value  method  to  evaluate  a  capital  
expenditure  proposal?  
-­‐ NPV  considers  the  time  value  of  money  and  involves  a  3-­‐steps  process:  
1) determine  initial  (present  time)  cash  payment  needed  to  implement  proposal  
2) determine  present  value  of  expected  future  net  cash  receipts  from  proposal  
3) determine  NPV  by  subtracting  amount  in  Step  1  from  amount  in  step  2  
-­‐ note  that  NPV  is  net  outcome;  if  NPV  is  zero/positive,  proposal  is  acceptable  
as  it’ll  earn  at  least  the  required  rate  of  return  
-­‐ adv  of  NPV:  expected  cash  flows  &  timing  are  
considered,  decision  rule  is  explicit  
-­‐ disadv:  relies  on  discount  rate,  actual  return  in  
terms  of  %  investment  outlay  isn’t  revealed  
 
What  is  the  difference  between  the  payback  method  and  the  accg  rate  of  return  on  
investment  method  for  evaluating  a  capital  expenditure  proposal?  
-­‐ this  evaluates  a  capital  expenditure  proposal  based  on  the  payback  period  
-­‐ payback  period-­‐length  of  time  required  for  a  return  of  initial  investment  
-­‐ decision:  accept  project  with  shortest  payback  period  
-­‐ example:  payback  period  is  3.009  yrs  (100/11000=0.009)  
-­‐ adv  of  payback  method:  simple  to  calculate,  easy  to  understand,  incorporates  
awareness  of  risk  in  decisions  
 -­‐
disadv:  ignores  time  value  of  money  &  cash  inflow  after  payback,  too  simple  
to  be  used  as  a  decision  support  tool  by  itself  
Accounting  rate  of  return  method  (ARR)  
!"#$!%#  !""#!$  !"#  !"#!  !"#$  !"#$  !""#$!!""#!$  !"#$"%&'(&)*  !"  !""#$
-­‐ ARR= (!"#$%&  !"#$%&!"  !"  !""#$  !"!  !"!#!$%  !"#$!!"#$%&'(  !"#$%)/!
 
-­‐ Average  annual  net  cash  flow  from  asset  =  
!"#  !"  !"#!  !"#$  !"!  !"#!  !"#"$%&'!!"#$%&'(
!".!"  !"#$  !"#$%&'
 
!"!#!$%  !"#$!!"#$%&'(
-­‐ Annual  depreciation  on  asset  =   !".!"  !"#$  !"#$%&'
 
-­‐ Useful  in  comparing  several  different  projects  as  ARR  can  be  ranked  but  it  
ignores  time  value  of  money  
-­‐ ARR  should  be  used  in  support  of  the  NPV  method    
-­‐ Decision:  project  with  highest  ARR  (which  is  also  higher  than  required  return  
and  also  has  positive  NPV)  is  usually  chosen  
-­‐ Adv  of  ARR:  simple  to  calculate,  easy  to  understand,  consistent  with  return  
on  assets  (ROA)  measure  
-­‐ Disadv:  time  value  of  money  is  ignored,  importance  of  cash  is  ignored,  profits  
and  costs  maybe  measured  in  different  ways  
 
How  does  a  business  decide  which  capital  expenditure  proposal  to  accept  when  it  
has  several  proposals  that  accomplish  the  same  thing,  or  when  it  cannot  obtain  
sufficient  cash  to  make  all  of  its  desired  investments?  
Mutually  exclusive  capital  expenditure  proposals  
-­‐ refers  to  proposals  that  accomplish  the  same  thing,  so  that  when  1  proposal  
is  selected,  the  others  are  not  (e.g.  considering  buying  aircon)  
-­‐ Step  1:  analyse  each  proposal  to  determine  whether  or  not  it’s  acceptable  
-­‐ Step  2:  select  one  of  the  acceptable  alternatives  by  choosing  proposal  with  
highest  positive  NPV  
Capital  Rationing  
-­‐ occurs  when  business  cannot  obtain  sufficient  cash  to  make  all  investments  
that  it  would  like  to  make  
-­‐ business  chooses  combo  of  capital  expenditure  proposals  that  provides  the  
highest  total  NPV  for  the  total  investment  available  
Practical  Issues  
1) collecting  data:  costs,  revenues  and  cash  flows  may  not  be  easy  to  determine  
2) opportunity  costs:  cost  of  foregoing  benefits  of  other  alternative  proposals  
3) risk:  data  may  be  inaccurate;  changes  may  occur  in  the  future  
4) finance:  some  investments  seem  good  but  obtaining  loans  may  be  difficult  
5) human  resources:  will  there  be  employees/consultants  available  with  
required  skills  available  required  by  the  project?  
6) Social  responsibility  and  care  of  the  natural  environ:  can  affect  business  
decisions  (e.g.  pollution),  social  and  environ  costs  may  be  hard  to  estimate