Capital Expenditure Decisions
Prof Rajasree, IBS Kochi MBA, MS, CFA
Sem1 FM 1
Capital Expenditure Decision
Also called capital budgeting. A decision which involves company’s fund to be invested efficiently in long term projects/ assets in anticipation of an expected flow of benefits over a series of years. The project generally runs for long periods. Involves huge amount of investment. These decisions are irreversible in nature.
Steps in Capital Budgeting
Sources for project/ product idea Preliminary screening Feasibility Study Project Implementation Review
Sources for product ideas
Market characteristics of different Industries: if there exists a demand supply mismatch. E.g. Maggi noodles Imports and Exports: Government is keen on promoting export oriented and import substitution ind., hence potential investment opportunities can be found if imports and exports are studied. Emerging Technologies: analyzing the commercial viability of new technologies can provide opportunities. E.g. Xerox Backward and Forward Integration: own outputs can be used to make
products. E.g. Deepak Fertilizers manufacturing ammonia based fertilizer.
• The list of prospective investment opportunities are now subject to screening. Compatibility with promoter Compatibility with Governmental Priorities Availability of Raw material and utilities Size of potential market Cost Risk of the project
Once the project opportunity is chosen and it is considered acceptable after the preliminary screening, a feasibility study is to be conducted. Market & Demand, Technical, Financial Projections, Project Valuation, Economic, Social Cost Benefit and Risk Analysis aspects are looked into and a Detailed Project Report (DPR) is prepared. Fairly detailed estimates of project cost, means of financing, estimates of cost and benefit streams in terms of cash flows, estimates of profitability, debt servicing capability, & social profitability is conducted.
Implementation and Review
• Stages of Implementation:
– Negotiating for finances from various sources – Construction of building; Installation of machinery etc. – Training of engineers, technicians, workers etc – Commissioning of plant and trial run – Commercial production
Market & Demand Appraisal: total market and market share of the project Technical Appraisal: technical aspects like project design, quality and quantity of raw materials, scale of operations etc Financial Projections: project cash flow projections Project Valuation: Valuing the viability of a project Economic Appraisal: impact of project on social life of people around, employment, distribution of income in society, pollution etc. Social Cost Benefit analysis: keeping in mind the national objectives Risk analysis: the study of the inherent risks in the project
• Basic 2 steps involved: – Define stream of cash flows (inflows and outflows) associated. – Appraise the cash flow stream to determine whether the project is financially viable Assumptions – Cash flows occur only once in a year Risk of the project is same as that of other projects of the firm.
Calculating the CASH FLOWS
• All costs and benefits are measured in terms of CASH FLOWS. Hence all non cash expenses (depreciation) has to be added back to PAT in order to calculate operating Cash flow. • Interest on Long Term Loans are not deducted in calculation of
PAT. It is because the WACC used includes post tax cost of long term funds. Hence if Interest on LT funds are considered it will be double counting. • But interest on ST funds like Working capital and short term bank finance are considered.
Following are the extracts of a project in Company A:
Land Building Plant & Machinery Other FA
80 100 500 100
Project is financed by
Equity Share capital 12% Pref. Share capital 16% Term Loan 18% Bank Loan for WC
500 250 300 340
Technical Know how 160 Gross WC 450
The company is expected to generate sales value of Rs 10 crore in 1st, 12 crore in 2nd and 15 crore in next 3 years. Cost of production excluding depreciation would be 70% of sales. The rate of depreciation on building is 4% on SL method and 331/3 % WDV method on P&M and other FA. Tech. know how fees are written off over a period of 5 years. Salvage value of P&M after 5 years would be 20% of acquisition cost, nil for other FA & book value for L&B. Term Loan for project will be repaid after 5 years when the project is sold. Tax rate is 30% and COC is 20%.
To judge the viability of a project
Payback period Accounting rate of return
Non – Discounting
NPV Benefit Cost Ratio Internal Rate of Return Annual Capital Charge
• Following data is available for two projects A and B.
Years 1 2 3 4 5 Cash Outflows (lakh) Project A 9 7 2 3 1 Project B 10 15 20 8 -Cash Inflows (lakh) Project A 10 15 12 10 9 Project B 15 25 40 50 --
Project A has life of 5 years and B has a life of 4 years. Initial investment in A and B are 5 lakh and 12 lakh respectively. Calculate: 1. NPV; 4. BCR; 2. IRR; 3. Payback period;
5. NBCR and 6. ACC