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LONG-TERM INVESTMENT DECISIONS

Long-term investment is a type of non-current asset, means holding assets such as

stocks, shares or securities for a long time.

a) Security – is a very common type of long-term investment we could be talking to bond,

equity, and stock.
b) Tangible Fixed Asset – Not used in day to day operations. Example: Land.
c) Funds – Example: pension funds, sinking funds, and life insurance.

Importance of Long-term investment

1. Time Period – Long-term investment have sufficient time period to grow and enough space
to investors to understand the market trends and features of a particular product in a long
run.
2. Power Compounding – In the long run, the power compounding works wonders. Invest
early and see money multiplies manifolds specifically in case of long-term investment.
3. Diversified Portfolio – Diversification allows your portfolio to grow well both long-term and
short-term investment provide cushion to the investors and maintain a balance in liquidity
built.
4. Disposal Time – Long-term investment allows the investors to study the features of a
particular stock or invest in a long run.

A. COST OF CAPITAL

In economics and accounting, the cost of capital is the cost of a company's funds (both
debt and equity), or, the required rate of return on a portfolio company's existing securities. It is
used to evaluate new projects of a company. It is the minimum return that investors expect for
providing capital to the company, thus setting a benchmark that a new project has to meet
[ CITATION Wik20 \l 1033 ].

The cost of capital metric is used by companies internally to judge whether a capital
project is worth the expenditure of resources, and by investors who use it to determine whether
an investment is worth the risk compared to the return. The cost of capital depends on the mode
of financing used. It refers to the cost of equity if the business is financed solely through equity

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or to the cost of debt if it is financed solely through debt. Some companies use a combination of
debt and equity to finance their businesses[ CITATION Wil20 \l 1033 ].

1. Concept of Cost of Capital

A firm raises funds from various sources, which are called the components of capital.
Different sources of fund or the components of capital have different costs. For example, the
cost of raising funds through issuing equity shares is different from that of raising funds through
issuing preference shares. The cost of each source is the specific cost of that source, the
average of which gives the overall cost for acquiring capital. The firm invests the funds in
various assets. It should earn returns that are higher than the cost of raising the funds
[ CITATION Tri20 \l 1033 ].

In the operational sense, cost of capital is the discount rate used to determine the present
value of estimated future cash inflows of a project. Thus, it is the rate of return a firm must earn
on a project to maintain its present market value [ CITATION Tri20 \l 1033 ].

In the economic sense, it is the weighted average cost of capital, i.e. the cost of borrowing
funds. A firm raises funds from different sources. The cost of each source is called specific cost
of capital. The average of each specific source is referred to as weighted average cost of
capital[ CITATION Tri20 \l 1033 ].

Milton H. Spencer defines cost of capital as the minimum required rate of return which a firm
requires as a condition for undertaking an investment.

According to Ezra Solomon, the cost of capital is the minimum required rate of earnings or
the cut-off rate of capital expenditure.

L. J. Gitman defines the cost of capital as the rate of return a firm must earn on its
investment so the market value of the firm remains unchanged.

2. Nature of Cost of Capital

a) Source of finance

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 A firm's Cost of capital is the cost it must pay to raise funds — either by selling bonds,
borrowing, or equity financing. Organizations typically define their own "cost of capital" in one of
two ways [ CITATION Mar20 \l 1033 ]:

i. Cost of capital is merely the financing cost the organization must pay when borrowing
funds, either by securing a loan or by selling bonds, or equity financing. In either case,
the cost of capital appears as an annual interest rate, such as 6%, or 8.2%.

ii. Evaluating a potential investment (e.g., a significant purchase), the Cost of capital is the
return rate the firm could earn if it invested instead in an alternative venture with the
same risk. As a result, Cost of capital is essentially the opportunity cost of using capital
resources for a specific purpose.

b) Corresponding payment for using finance.

On raising funds from the market, from various sources, the firm has to pay some additional
amount, apart from the principal itself. The additional amount is nothing but the cost of using the
capital, i.e. cost of capital which is either paid in lump sum or at periodic intervals [ CITATION
Bus20 \l 1033 ],

3. Calculating the Cost of Capital

Cost of capital is measured for different sources of capital structure of a firm. It includes cost
of cost of debt, cost of equity, cost of retained earnings, and cost of preference share capital
(Weighted average cost of capital).

Cost of
Cost of Equity Retained
Earnings

Cost of
Cost of Debt Preference
Weighted Share Capital
Average
Cost of
Capital
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 Illustration from [ CITATION Bus20 \l
Computation of cost of capital of a firm involves the following:
1033 ]

i. Computation of cost of each specific source of finance

A. Cost of Debt – Generally, cost of debt capital refers to the total cost or the rate of interest
paid by an organization in raising debt capital. However, in a real situation, total interest paid
for raising debt capital is not considered as cost of debt because the total interest is treated
as an expense and deducted from tax. This reduces the tax liability of an organization
[ CITATION Che20 \l 1033 ].
Moreover, it appears as a percentage in either of two ways: First, before-tax, and
second, after tax. In cases where interest expenses are tax deductible, the after-tax approach is
generally considered more accurate or more appropriate. The after-tax cost of debt is always
lower than the before-tax version [ CITATION Mar20 \l 1033 ].
Lenders, investors, and business owners calculate cost of debt in different ways, but the
most common cost of debt formula is [ CITATION Pri20 \l 1033 ]:

Kd = Interest Expense (1 – T)

Kd is the Cost of Debt and T is the corporate rate. Tax is included in debt as debt is
discounted as a deductible expense.

Example:

For a company with an income tax rate of 35% and a before-tax cost of debt of 6%, the
after-tax cost of debt is as follows:

After-tax cost of debt = (Before tax cost of debt) x (1 –tax rate)

= (0.06) x (1.00 – 0.35)

= (0.06) x (0.65)

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 = 0.039 or 3.9%

B. Cost of Equity – The cost of equity is the return a company requires to decide if an
investment meets capital return requirements. Firms often use it as a capital budgeting
threshold for the required rate of return. A firm's cost of equity represents the compensation
the market demands in exchange for owning the asset and bearing the risk of ownership
[ CITATION Wil202 \l 1033 ].
The cost incurred by a company when new common stock is sold. Capital from existing
stockholders is internal equity capital. The firm already has these funds. In contrast, capital from
issuing new stock is external equity capital. The firm is trying to raise new funds from outside
sources.
The funds required for a project may be raised by the issue of equity shares which are
permanent nature. These funds are not repayable during the lifetime of the organization.
Calculation of the cost of equity shares is complicated because, unlike debt and preference
shares, there is no fixed rate of interest or dividend payment. Cost of equity share is calculated
by considering the earnings of the company, market value of the shares, dividend per share and
the growth rate of dividend or earnings [ CITATION San20 \l 1033 ].
There are two ways to calculate cost of equity: using the dividend capitalization model or
the capital asset pricing model (CAPM). The dividend capitalization model requires that the
stock are analyzing earns dividends. If the investment in question does not earn dividends, the
CAPM formula should be use, which is based on estimates about the company and stock
market [ CITATION Mad19 \l 1033 ].

1) Dividend capitalization model:

Formula: Ke = (D1 / P0) + g

Where: Ke = Cost of Equity (the rate of return on equity based dividends)

D1 = Yearly dividends per share (the total of dividends that one share in a
company earns in one year)
P0 = Share price (the current price of one share in a company’s stock)

g = Dividend growth rate (the rate at which company dividends have

historically grown)

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 This model does not account for stock appreciation or risk. It also presumes that the
dividend payment will go up rather than stay the same or go down.

New stock is sometimes issued to finance a capital budgeting project. The cost of this
capital includes not only stockholders’ expected returns on their investment but also the
floatation costs incurred to issue new securities. Floatation cost make the cost of using funds
supplied by new stockholders slightly higher than using retained earnings supplied by the
existing stockholders [ CITATION Tim07 \l 1033 ].

Formula: Ke = (D1 / P0 – F) + g

Where: Ke = Cost of Equity (the rate of return on equity based dividends)

D1 = Yearly dividends per share (the total of dividends that one share in a
company earns in one year)
Po = Share price (the current price of one share in a company’s stock)

F = Floatation cost per share

g = Dividend growth rate (the rate at which company dividends have

historically grown)

2) Capital asset pricing model (CAPM): The firm may choose to use the CAPM to calculate
the rate of return that investors require for holding common stock [ CITATION Tim07 \l 1033
]. The cost of equity is inferred by comparing the investment to other investments
(comparable) with similar risk profiles. It is commonly computed using the capital asset
pricing model formula [ CITATION Wik20 \l 1033 ]:

Formula: E(Ri) = Rf + βi (E(Rm) - Rf)

Where: E(Ri) = Expected return on investment (the rate of return on equity based
on the expected return on investment on an asset)

Rf = Risk-free rate of return (the interest rate of an investment with zero

risk)

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 βi = Beta of risk (the volatility of the investment compared to the general
market)

E(Rm) = Market risk (the overall risk of investing in the stock market, or
the expected return on investment in the stock market
minus risk- free rate)
C. Cost of Retained Earnings – Retained earnings represent a firm's cumulative earnings since
its inception that it has not paid out as dividends to common shareholders. Retained
earnings instead get plowed back into the firm for growth and use as part of the firm's capital
structure [ CITATION Ros19 \l 1033 ].
Retained earnings (RE) is the amount of net income left over for the business after it has
paid out dividends to its shareholders. The decision to retain the earnings or to distribute it
among the shareholders is usually left to the company management. A growth-focused
company may not pay dividends at all or pay very small amounts, as it may prefer to use the
retained earnings to finance expansion activities[ CITATION Wil201 \l 1033 ].

The cost of retained earnings can be measured as follows:

a. Where there are no taxes and brokerage fees:

Formula: Kr = Ke = (D1/NP) + g

Where: Kr = Cost of Retained Earnings

Ke = Cost of equity capital
D1 = Expected dividend per share
NP = Current selling price or net proceed
g = Growth Rate

b. Where there are taxes and brokerage fees:

Formula: Kr = Ke (1 - T) (1 - B)
Where: Kr = Cost of Retained Earnings
Ke = Cost of equity capital
T = Marginal tax rate of shareholder and
B = Brokerage or commission to acquire new shares.

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D. Cost of Preference Share Capital – An amount paid by company as dividend to preference
shareholder is known as Cost of Preference Share Capital. Preference share is a small unit
of a company’s capital which bears fixed rate of dividend and holder of it gets dividend when
company earn profit. Dividend payable is not a tax deductible amount. There is no tax
adjustments required for comparing with cost of debt [ CITATION Fin16 \l 1033 ].
Preferred stock differs from common equity in several ways. A beneficial distinction is
that preferred shareholders are first in line to receive any dividend payments. In the event of
liquidation, preferred shareholders are also the first to receive payments after bondholders, but
before common equity holders [ CITATION CFI20 \l 1033 ].

There are two types of preference shares: irredeemable and redeemable [ CITATION
MYK07 \l 1033 ].

a) Irredeemable – is a kind of perpetual security in that the principal is not to be returned for
a long time or is likely to be available until the life of the company

Formula: Kp = Dp / NP

Where: Kp = Cost of Preference Share

Dp = Dividend on preference share
NP = Net proceeds from issue of preference share

b) Redeemable – are issued with maturity date so that the principal will be repaid at some
future date.

Formula: Kp = Dp + ((RV-NP) /n ) / (RV+NP) / 2

Where: Kp = Cost of Preference Share

Dp = Dividend on preference share
NP = Net proceeds from issue of preference share
(Issue price – Flotation cost)
RV = Redemption Value
n = Period of preference share

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 ii. Computation of weighted average cost of capital (WACC)

A firm's cost of capital is typically calculated using the weighted average cost of capital
formula that considers the cost of both debt and equity capital. Each category of the firm's
capital is weighted proportionately to arrive at a blended rate, and the formula considers every
type of debt and equity on the company's balance sheet, including common and preferred stock,
bonds and other forms of debt [ CITATION Wil20 \l 1033 ].

The next step in finding a firm’s overall cost of capital is assessing the firm’s capital
structure. The assets of most firms are financed with a mixture of debt, preferred stock, and
common equity. The mixture of capital used to finance a firm’s assets is called the capital
structure of the firm. To analyze the capital structure of a business, we must find the percentage
of each type of capital source [ CITATION Tim07 \l 1033 ].

Formula: WACC = (E/V × Ke) + (D/V × Kd × (1−Tc))

Where: WACC = Weighted Average Cost of Capital

E = Market value of the firm’s equity
D = Market value of the firm’s debt
V=E+D
Ke = Cost of equity
Kd = Cost of debt
Tc = Corporate tax rate

WACC is calculated by multiplying the cost of each capital source (debt and equity) by
its relevant weight, and then adding the products together to determine the value. In the above
formula, E/V represents the proportion of equity-based financing, while D/V represents the
proportion of debt-based financing [ CITATION Sho19 \l 1033 ].

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 WACC formula is the summation of two terms: (E/V × Ke) and (D/V × Kd × (1−Tc))

An extended version of the WACC formula is shown below, which includes the cost of
Preferred Stock for companies that have it [ CITATION CFI201 \l 1033 ].

WACC = Cost of Equity x % Equity + Cost of Debt x % Debt x (1- Tax rate) + Cost of Preferred Stock x %
Preferred Stock

4. Factors to Consider in Calculating Cost of Capital

When firms’ needs additional or new funds they need to check the cost of capital.
Company can get the new money through shares and debt. On getting debt, they have to pay
cost of debt in the form of interest payment. On getting equity or preference share capital, they
have to pay dividend to shareholders [ CITATION Acc19 \l 1033 ]. In making optimal model of cost
of capital in which cost of capital will be minimum, firms have to study the factors to consider in
calculating the cost of capital. Following are the main factors that need to consider [ CITATION
Mir20 \l 1033 ]:

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 a) General Economic Conditions – This factor determines the risk-free or riskless rate of
return.
b) Market Conditions – Marketability of a company’s securities: as the marketability of
security increases, investor’s required rates of return a decrease, lowering the
corporation’s cost of capital.
c) Operating and Financing Decisions – Made by management. If management accepts
investments with high levels of risk or rate of return, which causes a higher cost of
capital to the company.
d) Amount of Financing – Amount of financing needed. Requests for larger amounts of
capital increases the firm’s cost of capital.

B. THE BASIS OF CAPITAL BUDGETING

Capital budgeting is the process that a business uses to determine which proposed fixed
asset purchases it should accept, and which should be declined. This process is used to create
a quantitative view of each proposed fixed asset investment, thereby giving a rational basis for
making a judgment [ CITATION Rod90 \l 1033 ].

Capital is the total investment of the company and budgeting is the art of building
budgets.

1. Concept of Capital Budgeting

Capital budgeting is a planning process that is used to determine the worth of long-term
investments of an organization. The long- term investments of the organization can be made in
purchasing new machinery, plant, and technology [ CITATION Acc20 \l 1033 ].

In other words, capital budgeting is a method of identifying, evaluating, and selecting

long-term investments. The concept of capital budgeting has a great importance in project
selection as it helps in planning capital required for completing long-term projects. Selection of a
project is a major investment decision for an organization.

Therefore, capital budgeting decisions are included in the selection of a project. In

addition, capital budgeting helps in estimating costs and benefits involved in a particular project.
A project is not worth investing, if it does not yield adequate return on invested capital.

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 2. Relevance of Capital Budgeting to Decision Making
Ideally, businesses would pursue any and all projects and opportunities that enhance
shareholder value and profit. However, because the amount of capital or money any business
has available for new projects is limited, management uses capital budgeting techniques to
determine which projects will yield the best return over an applicable period.

3. Features of Capital Budgeting

1) It involves high risk

2) Large profits are estimated

3) Long time period between the initial investments and estimated returns

4. Capital Budgeting Methods

Net present value analysis - Identify the net change in cash flows associated with a
fixed asset purchase, and discount them to their present value. Then compare all proposed
projects with positive net present values, and accept those with the highest net present values
until funds run out.

Present value of Future cash flow

a future cash flow = -----------------------------------------------------------------------------------

(1 + Discount rate) (Squared by the number of periods of discounting)

Using the preceding formula, if there is an expectation of receiving $150,000 in one year,
and the current discount rate is assumed to be 10%, then the calculated net present value of the
future cash receipt is:

$150,000

Present value = ------------------

(1 + .10)1

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Present value = $136,363.64

5. Constraint Analysis
Identify the bottleneck machine or work center in a production environment and invest in
those fixed assets that maximize the utilization of the bottleneck operation. Under this approach,
a business is less likely to invest in areas downstream from the bottleneck operation (since they
are constrained by the bottleneck operation) and more likely to invest upstream from the
bottleneck (since additional capacity there makes it easier to keep the bottleneck fully supplied
with inventory).

6. Payback Period
Determine the period required to generate sufficient cash flow from a project to pay for
the initial investment in it. This is essentially a risk measure, for the focus is on the period of
time that the investment is at risk of not being returned to the company.

7. Avoidance Analysis
Determine whether increased maintenance can be used to prolong the life of existing
assets, rather than investing in replacement assets. This analysis can substantially reduce a
company's total investment in fixed assets.

The amount of cash involved in a fixed asset investment may be so large that it could
lead to the bankruptcy of a firm if the investment fails. Consequently, capital budgeting is a
mandatory activity for larger fixed asset proposals. This is less of an issue for smaller
investments; in these latter cases, it is better to streamline the capital budgeting process
substantially, so that the focus is more on getting the investments made as expeditiously as
possible; by doing so, the operations of profit centers are not hindered by the analysis of their
fixed asset proposals.

8. Factors to be consider in calculating Capital Budget:

• Involves calculation of each project’s future accounting profit by period.

• Involves by cash flow by period.

• The present value of the cash flows after considering the value of money

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 • The number of years its takes for a project to pay back the initial investment.

• An assessment of risk

9. Factors Affecting Capital Budgeting

• Availability of Funds

• Structure of Capital

• Management Decisions

• Accounting methods

• Taxation Policy

• Lending terms of financial institutions

• Economic Value

• Working Capital

• Capital Return

• Need of the Project

• Government Policy

• Earnings

• Economic Value of the Project

C. SCREENING AND SELECTING CAPITAL INVESTMENT PROPOSALS

The first step towards capital budgeting is to generate a proposal for investment. There
could be various reasons for taking up investments in a business. It could be addition of a new
product line or expanding the existing one. It could be a proposal to either increase the
production or reduce the costs of outputs. [ CITATION VAA \l 1033 ]
The analysis stipulates a decision rule for:
I. Accepting or
II. Rejecting

1. Evaluation of Proposed Capital Expenditures

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 Proposed capital expenditures should be scrutinized since they involve large outlays of
funds. A number of primary factors should be considered by management. These are the
following [ CITATION Rob07 \l 1033 ]:

1. Urgency – Decisions should be made as quickly as possible for requirements that are
urgent.
2. Repairs – Management should consider the availability of spare sparts and maintenance
experts. When these are critical and they are not available, the concerned proposal
should be ruled out.
3. Credit – This factor should be considered in the sense that some credit may be highly
favorable to the company
4. Non-Economic Factors –These refers to social considerations, and other non-economic
persuasions and preferences
5. Investment Worth – This refers to the economic evaluation of a certain proposal
6. Risk Involved – This refers to the uncertainty of an expected return

2. Methods of Economic Evaluation

Since the primary objective of the firm is to make profits, every business activity should
be directed towards achieving this end. Capital investments are not exempted from this
requirement. It is, therefore, a requirement that investment proposals should be analyzed and a
determination of their economic value to the firm should be made.

There are three basic method of evaluating proposals. These are composed of the
following: (1) the payback method; (2) the average rate of return; and (3) the discounted
cash flow methods. These methods will be discussed in succeeding pages using data.

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 1) The Payback Method

The payback method determines the number of years required to recover the cash
investment made on a project. The recovery of cash comes from the cash inflows generated
from the project. The formula used is as follows:

Substituting data, the payback method is presented as

The cost of machinery is expected to be recovered in full after 4.2 years. The payback
method is simple and easy to understand. When the firm does not favor exposure of its own
investments for longer periods, the proposal is rejected. This decision can be made quickly with
the use of the payback method.

The payback method however has some disadvantages. These are the following:

 It does not consider the time value of money

 The accept-reject criterion is stated in terms of years rather than at a discount rate
 The firm’s attention is focused on cash flow rather than on rate of return
 Careful projection of the timing of the investment outlays and the year-by-year
projection of cash inflows over the entire life of the proposal are not encouraged; and
 The salvage value of the proposal is not considered

2) The Average Rate of Return Methods

The average rate of return methods consists of the following: (a) the average return on
investment; (b) the average return on average investment [ CITATION Rob07 \l 1033 ].

a. Average Return on Investment – It shows the ratio of the average cash inflow to the
investment. This method is simple and is easy to compute. The formula is as follows:

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 Substituting data, we have

The advantage of this method is that it is very easy to compute and the available
accounting data may be readily used. Its main disadvantage, however, is that it does not take
into account the time value of money.
b. Average Return on Average Investment - this method is similar to the average
return on investment method except that the effect of the depreciation charge on the
investment is taken into consideration. The formula is as follows:

Substituting data, the computation is shown as follows:

Under this method, the initial investment outlay is divided by two to derive the average
balance of the investment as it is decreased periodically by the depreciation charge. This
method is also simple and easy to compute. The true rate of return is, however, overstated.
Moreover, it does not also consider the time value of money.

3) Discounted Cash Flow Methods

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 The time value of money is recognized under the discounted cash flow methods. These
are two approaches available: (a) the net present value method; and (b) the internal rate of
return method. Under these approaches, all future values of a proposal are discounted and
compared to the values of other proposals. The discounting factor makes these two method
preferred by users in evaluating capital expenditure proposals [ CITATION Rob07 \l 1033 ].

a. Net Present Value Method – Under this method, a desired rate of return is used for
discounting purposes. The present value concepts are applied to the cash flows of a
proposal and are discounted at the desired rate of return for the periods involved. The
sum of the present values of the outflows is compared with the sum of the present values
of the inflows. If the discounted cash inflows are larger than the discounted cash outflows,
the project will earn more than the desired rate of return. The proposal is accepted.
Conversely, if the discounted cash outflows are larger than the discounted cash inflows,
the project will not be able to generate the desired minimum rate of return. The proposal
is, then, rejected. To illustrate, the following formula and computation are presented as
follows:

NPV = PVCI – PVCO

Where NPV = net present value (also the net value derived after deducting the
discounted cash outflow from the discounted cash inflow)

PVCI = discounted value of the anticipated cash inflows

PVCO = discounted value of the anticipated cash outflows

The formula for finding the present value of an expected cash inflow is as follows:

A
PV = (1+ R)
n

Where: A = expected cash inflow

R = desired rate of return

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 n = number of years the cash inflow is expected

If the desired rate of return is 25%, the cash inflows for the ten-year period may be
computed to determine the present value for each year. For example, the present value of the
cash inflow for the second year is computed as follows:

₱ 2,380,000 ₱ 2,380,000
PV of cash inflow, year 2 = 2 = 2
=₱ 1,523,200
(1+.25) (1.25)

Applying the present value formula, the present values of the cash flows will appear as follows:

To find out the net present value of the proposal presented in the formula earlier stated
is applied as follows:
NPV = PVCI – PVCO

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 = ₱ 8,508,490 - ₱ 10,000,000

= - (₱ 1,491,510)

The computation shows a negative net present value indicating that the sum of the
discounted cash outflow is greater than the sum of the discounted cash inflows. On this, the
proposal is rejected.

b. Internal Rate of Return Method – this method and the net present value method use
the discount rate as factors. The difference however, is that the internal rate of return
method, the discount rate is not given. Rather, it becomes the object of computation.
The discount rate which will yield a net present value of zero or one approximating
zero is the correct discount rate. This means that the present value of the cash inflows
is equal to the present value of the cash outflows. The correct discount rate may be
determined by trial and error.

The acceptability of the proposal will depend on the prevailing interest rates as
compared with the computed correct discount rate. If the prevailing rate is higher, the proposal
is rejected, and conversely, if it is lower, the proposal is accepted.

In our computation of the preceding method, a negative net present value of ₱ 1,491,510
was shown. Since the discount rate of 25% was used, an attempt to find the correct discount
rate will be made using one which is lower than 25%. Computation using various discount rates
applicable to the example shown in the preceding method is shown below.

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 The net present values at different discount rates may now be computed as follows:

a. NPV at 22% discount rate

= PVCI – PVCO
= ₱ 9,350,800 - ₱ 10,000,000
= - (₱ 649,200)
b. NPV at 21% discount rate
= PVCI – PVCO
= ₱ 9,603,520 - ₱ 10,000,000
= - (₱ 396,480)
c. NPV at 20% discount rate
= PVCI – PVCO
= ₱ 9,994,080 - ₱ 10,000,000
= - (₱ 5,920)

The result of the computation shows net present values at different discount rates.
Obviously, the discount rate which yields the net present nearest to zero is 20%. If the standard
interest is below 20%, the proposal is accepted.

3. Risk, Uncertainty and Sensitivity

Among the primary factors considered in the evaluation of proposed capital

expenditures, the uncertainty of expected returns pose a challenge to one who manages the
firm’s finances. In the preceding discussion of the method of economic evaluation, it is assumed
that the returns are certain. This is misleading because one can never be fully certain about the
results that will be obtained from an investment.

4. Factors Affecting Risk

There are four primary factors involved in the evaluation of risks pertaining to capital
expenditures. These are the following:

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 1. Possible inaccuracy of the figures used in the evaluation

2. Type of business involved

3. Type of physical plant and equipment involved

4. The length of time that must pass before all the conditions of the evaluation become
fulfilled

Estimates could be wrong or inaccurate at times. Accuracy, however, depends on how

the figures were obtained. Estimates can be made either by scientific methods or by plain
guesswork. A certain degree of reliability can be assigned to the former and none to the latter
method.
Every type of business has its own degree of risk that is peculiar to itself. One line may
be more stable in terms of demand than the others. The demand for food, for instance, is more
stable than the demand for specialized consumer items like hair dyes. Also, more risk is
involved in the operations of a new venture than a business with a successful record of past
performance.
Physical plants and equipment are also subject to risks. Some may become obsolete
before their economic life expires. The demand for special equipment, like that for DVD players,
may be diminishing without warning.
Finally, estimates involving longer periods are usually more prone to inaccuracies than
those involving shorter periods. This is true because, most often, changes in the environment
happen sooner than expected.

5. Sensitivity Analysis

The expected returns on investment may change as changes in some relevant factors
happen. Capacity utilization at various levels, for instance, may yield various rates of return on
investment. As capacity utilization depends mostly on some relevant factors like the availability
of raw materials, it is important that an analysis of the expected returns be made on various
utilization levels. This is actually finding the sensitivity of an investment to various changes.

Sensitivity analysis is applicable to capital expenditures involving the purchase or

construction of a plant. It is useful for management to know the expected returns that will be
generated by the various capacity utilization in the operation of the plant. Consider the following
example:

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 The example cited above indicates that by using the plant at full capacity, the return will
be at its highest level, which is 43%. However, if because of some factors, this is not possible,
the expected return will still be 36% at 75% capacity operation, and 25% at 50% capacity
operation. If the prevailing interest rate is below 25%, the proposal should be accepted.

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