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You are on page 1of 23

Lecturer: Masud Muhammad

CHAPTER COVERAGE

At the end of this topic, you should be able to:

Explain capital investment;

Apply various capital investment appraisal techniques;

Examine the effects of inflation and taxation in capital investment

appraisal;

Identify risks and uncertainty, sensitivity analysis and capital rationing;

and nalyse ethical issues and other qualitative factors in long-term

decision making.

11. INTRODUCTION

Managers often make decisions involving an investment today with the hope

to get returns in the future. All of investments require significant initial capital

or fund outlay with the hope of getting a return of extra cash flows in the

future.

These significant investment decisions in projects that have long-term

implications and benefits are known as capital budgeting or capital

investment decisions. There could be many potential projects but the

availability of funds is a major constraint. Therefore, managers must

thoroughly evaluate and choose projects with the highest future returns.

APPRAISAL TECHNIQUES

Generally, any decision that requires an outlay (initial investment) now in

expectation of future benefit or return is a capital budgeting decision. Below

are some examples of capital budgeting or investment decisions, which

demand thorough and well thought planning.

(a) Lease or purchase decision Whether a new machine should be leased

or purchased;

(b) Expansion decision Whether a new building, warehouse or any facility

should be acquired to increase capacity and sales;

(c) Equipment replacement decision Whether outdated machine should

be replaced now or later; and

(d) Cost-reduction decision Whether a new piece of equipment should be

acquired to reduce costs.

The capital investment decisions would involve planning, setting targets and

priorities, arranging financing and using a set of criteria for making the

selection of long-term assets and commitments.

Poor capital investment decisions can be very costly because they affect the

long-run profitability of a company since huge amounts of resources are

invested and at risk for long period of time.

(a) Accounting rate of return;

(b) Discounted payback;

(c) Internal rate of return; and

(d) Payback;

(e) Net present value;

(f) Profitability index.

Accounting rate of return (ARR) is also known as the return on investment,

simple rate of return and the return on capital employed. The formula for

computing ARR is

ARR = Average annual profit or Average income / Average

investment

ARR measures the return on a project in terms of income or profit instead of

cash flows.

Income or profit is different from cash flows because the computation of

income statement uses the accrual basis.

Discuss the advantages and disadvantages of ARR.

11.1.2 Payback

The payback method is very popular, widely used, and can be considered as the

easiest and most straightforward method. Payback period refers to the time

required for a firm to recover its original investment.

Consider the following two capital investments A and B. Both projects require

the same amount of initial investment of RM300,000 and have a 4-year life. The

expected cash flows for A and B are as follows.

Investment

Year 1

Year 2

Year 3

RM150,000

RM100,000

Year 4

RM100,000

RM50,000 RM100,000

Calculate the Payback period for two projects, suggest the best option and

discuss the pros and cons.

In order to overcome a deficiency of the payback model with regard to the

time value of money, we may adjust the computation of the payback period

by using cash flows that are discounted first to their present values. This

adjustment on the cash flows is referred to as adjusted or discounted

payback method.

(NPV)

NPV

measures the profitability of an investment by looking at the difference

in the present value of the cash inflows and outflows associated with the

capital investment.

NPV = (PV of cash inflows PV of cash outflows) Investment Outlay

NPV = PV of net cash flows - Investment Outlay

- I0

Calculate the Net Present Value of the following investment at 10% cost of

capital. Discuss the advantages and disadvantages of this method of

appraisal.

Project A

Cash flows

Investment

(100,000)

Year 1

22,727

Year 2

20,660

Year 3

18,783

Year 4

27,320

Year 5

31,045

Year 6

28,225

Year 7

25,660

Return (IRR)

Similar to NPV, internal rate of return considers the time value of money. The

internal rate of return is the interest (represented by i or K) rate or the

discount rate (also known as discounted rate of return) that will make the

NPV of an investment zero.

At this point, the present value of cash receipts is equal to the present value

of cash outlays. In other words, IRR specifies the maximum cost of capital

that can be committed to finance a capital investment without negatively

affecting the value to the shareholders.

In some scenarios, there are several potential projects with positive NPVs but

there are limited funds available to finance those projects. Thus, we need to

rank and prioritise the projects according to their profitability. How do we

rank potential capital investments? One way to do it is by ranking them

according to their NPVs. Alternatively, we may rank them by their profitability

index.

Profitability index is computed as follows:

Profitability Index = Present value of project / Investment outlay

Calculate the profitability index

of these projects.

Projec Investme

ts

nt

PV of Cash inflows

150,000

245,000

100,000

190,000

90,000

150,000

Although sometimes a company has many potential capital investment

projects with positive NPVs, whether the company can take up all the projects

is subject to availability of funds to finance those investments. There are

situations where funds are limited or insufficient to finance all projects.

Management may impose a budget ceiling (for various reasons), limiting the

amount of funds available for investments in any particular period.

Companies may set such policies upon all capital investments that are

financed by internal funds. This internal limitation on fund availability is

referred to as soft capital rationing.

Funds may also be insufficient or limited due to external constraints, such as

difficulty in getting funds from the financial markets. Then this situation is

called as hard capital rationing.

The company have

allocated RM50 million

fund for capital

investment for the

period.

Rank the projects based

on NPV and Profitability

Index and suggest the

best combination.

Discuss the advantages

and disadvantages and

possible consequences.

How does inflation affect capital investment decisions?

Fundamentally, inflation affects both the future cash flows and the required

return on the investment, which is the discount rate

In terms of cash flows, expected inflation may increase your future cash flows

but it does not mean you are better off, and your purchasing power will

remain the same.

Nominal cash flow = Real cash flow (1 + Expected inflation rate) n

(1 + nominal rate of return) = (1 + real rate of return) ( 1 + expected rate

inflation)

EFFECT OF TAXATION

The company has collected the following data for further analysis:

Cost of equipment

RM1,500,000

RM 600,000

RM1,000,000

RM 550,000

RM 200,000

RM 500,000

Assume the company ceases after 10 years, and thus the business will be

closed that year. The equipment would then be sold at its salvage value. The

companys after tax cost of capital is 12% and its tax rate is 25%. The

company uses the straight line method, assuming no salvage value for

computing tax-shield purposes.

SENSITIVITY ANALYSIS

Making investment decisions entails careful analysis and evaluation because

various types of investments carry different degrees of risk and uncertainty.

Studies of past returns show that investors require higher expected returns

for investing in risky securities, and the safest investment has the lowest

average rate of return.

This relationship is described in a model called capital asset pricing model

(CAPM). The relationship between expected returns and risk (measured in

terms of beta) is represented by a sloping line, called the security market

line. This security market line can be used to establish the expected return on

any security.

CAPM

Consider the following example to calculate the expected return on these

investments

Sensitivity Analysis:

These variables include estimated cost of capital (the i), estimated life of the

project (the n), estimated initial outlay (the I), and estimated stream of cash

flows that can be broken up into selling price, sales volume, and operating

costs.

QUALITATIVE FACTORS IN LONG-TERM

DECISION MAKING

Managers can make sound capital investment decisions after considering

quantitative factors like the NPV, IRR, and profitability index, as well as the

qualitative factors. Nevertheless, sometimes managers may not make

investment decisions in the best interest of the company. What might cause

or motivate managers to do that?

Modifying figures for getting approval

Pressure over short-term results

Myopic Behaviour

Factors

Despite those quantitative measurements like NPV, payback period and IRR,

qualitative factors are equally important when making capital investment

decisions. Some of the qualitative factors include company culture, ethics,

safety and environmental concerns

Environmental Considerations

Ethical Concerns

Company Culture

Balance between cost and quality

Image and reputation

SUMMARY

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