Planning and control of capital expenditure

The importance of capital expenditure decisions
from Hardy Heating Co. Ltd. by G. Ray and J. Smith published by the B.B.C., 1968

Planning and control of capital expenditure
Capital expenditure decisions are some of the most formidable that have to be made by management.
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When decision made to invest in long-lived assets, company usually committing itself to operating those assets for some time, reversal of decision will probably mean selling assets at a loss. decisions shape bed on which the company must lie in the future,

‡ Thus, investment decisions are mutually important to shareholder, employee, consumer and economy as a whole. ‡ Shareholder interested since capital expenditure decisions affect earning power and growth. ‡ Employee affected since investment may result in an improvement in profits and productivity, from which he may expect increased earnings. ‡ Consumer hopes to benefit from an increase in productivity by an improvement in quality or reduction in price. ‡ The economy as a whole is affected by the total volume of the investment, together with its timing and quality. ‡ We can consider the total investment in a company as a series of projects or investment decisions.

‡ In the traditional accounting statements, emphasis is placed on vertical rectangle below which represents a cross-section of projects during a one year period ‡ whereas, in capital expenditure decisions, concentration is on individual projects such as A (etc.), which cover number of years

Essential problem in capital investment appraisal
Following diagram shows the pattern of cash inflows and outflows which may be involved in capital expenditure decision.

‡ Essential problem: to determine whether cash outflow involved in investment is justified by cash inflows to be created over its life. ‡ Factors needing evaluating, and illustrated by above diagram: 1 2 3 4 initial cost of project; phasing of expenditure over project; estimated life of investment; amount and timing of resulting income.

‡ Outflow of funds needed to acquire capital asset is called 'the investment'. ‡ In case of renewal project (for example, replacement of an existing asset), investment will not be cost of the asset, but amount of funds needed to cover the difference between cost of new asset and trade-in or scrap value of old one.

Comparison of returns with investment
Capital expenditure decisions involve comparing the two µstreams¶ of funds, and if returns less investment is positive, a favourable decision may be indicated. However, the two streams flow at different times. In many projects, returns from initial investment outlay are obtained over long period of time. Necessary to make some adjustment for this time difference:

‡ must wait for returns to occur and waiting implies uncertainty due to inherent difficulty of long-term forecasting. ‡ waiting involves the sacrifice of present consumption or other investment opportunities. ‡ adjustment for the time differential, taking into account both uncertainty and sacrifice of alternative uses of funds, is known as discounting. ‡ effect of discounting is to express the two streams of investment and returns in present value equivalents. ‡ discount rate must be selected with care and represents a most important management decision. ‡ discount rate is related to cost of capital to the company, and is ‡ often expressed as the required earnings rate. ‡ incidence of taxation has a significant effect on the timing of the streams of investment and returns.

If the equation results in a positive figure: TOTAL PRESENT VALUE OF RETURNS (AFTER TAX CHARGES) u TOTAL PRESENT VALUE OF INVESTMENT (AFTER TAX RELIEF) Capital expenditure project appears successful.

Capital Expenditure management programme
Distinct dangers in concentrating too heavily on evaluation aspects of budgeting for capital expenditure projects. To place evaluation techniques in proper perspective, main components of capital expenditure management programme should be looked at.

1

The search for profitable opportunities.
Technological change increases and product & process life cycles become shorter --> more intense search for new and more profitable activities Management: organise to ensure have constant flow of investment opportunities for appraisal. Involves: ‡ market research, economic forecasting, ‡ cost estimating, profitability analysis, simulation. Management: look into future; try to measure economic attractiveness. Accountant: recognise assumptions and identify intangibles

2

Identification of relevant alternatives
Rarely only one way of carrying out a project, and careful evaluation of alternatives essential. When considering, e.g., machinery to carry out specified tasks, frequently are several new machines performing satisfactorily, but each might involve different investment and different flow of returns. Often existing machine need not be replaced this year, Therefore, timing of replacement needs considering. Satisfactory decision must begin with considering best alternatives.

3

Determination of costs and revenues
Costs and revenues relevant to capital expenditure decision are those arising from decision to invest. Emphasis is on future incremental cash flows and not on traditional historical cost accumulation. Cash flows and not book values are important in the long run assessment. Information used for evaluation may, therefore, be different from that shown in accounting statements

4

The screening and ranking of projects.

Next: Does project offers satisfactory returns? Minimum satisfactory rate of return ? Firm's cost of capital is one factor here. Rank satisfactory projects in attractiveness order. Ranking: measure benefits of projects, in a way to compare them Management must exercise judgement: before and after evaluation stage, on issues of overall company strategy. These factors may not all be included when computing return on investment.

5

The administrative control system.

Management:
Develop procedures for authorisation of expenditure. Then, controls are needed to ensure expenditure conforms to specification and is within authorisation amount. Periodic statements to assess progress and outstanding commitments. Statements audited: Helps accuracy of future estimates, and to apply benefits of experience to future projects Devise procedures to cover disposal of assets when asset market value exceeds future earnings value

CASES

A capital expenditure decision (1 )
Samantha Howell (M.D.) been considering problem of replacement of one of automatic moulding machines, and has had some discussions with John Marsh (Accountant). Apparently three possible alternatives: a) Tri-Rod machine, nearly same as present machine, and from same British supplier; b) Polidot machine from France; and c) American Plastidex machine.

‡ John: Need: Proper evaluation of alternatives Estimate cash flows for each alternative. ‡ Samantha: Done this with Jean Wilkins. Produced following figures:
Tri-Rod (A) Initial Outlay: Cash Inflows : Year £ 1 2 3 4 5 6 10,000 1,000 2,000 3,000 3,000 3,000 3,400 15,400 Polidot (B) 10,000 4,000 3,000 3,000 1,000 500 500 12,000 Plastidex (C) 10,000 3,000 3,000 3,000 3,000 2,000 1,000 15,000

‡ Samantha: ‡ Figures are approximate, but are best estimates. ‡ John: ‡ Three methods of evaluating capital expenditure decisions

1 2 3

Payback. Unadjusted rate of return. Discounted cash flow.

‡ Are weaknesses and strengths of various capital expenditure decision methods.

1

PAYBACK
John: Objective: to calculate time when: Project cash inflow equals initial outflow. Method gives following results: Machine: A B C

Payback period (years ) 41/3 3 Samantha:

31/3

Method tells us when we will get our money back. Suggests we should invest in Machine B.

‡ Samantha:
‡ But we should also be interested in rate of return on capital employed. ‡ This method does not tell us the return we are making after covering initial outlay

‡ John:
‡ Also: ‡ Another major weakness of payback method is that it ignores the timing of cash flows

2 UNADJUSTED (ACCOUNTING) RATE OF RETURN (A.R.R.)
John: Unadjusted Rate of Return calculates average annual profit as percentage of original outlay:
Machine A £ Total profit (6 years) 5,400 Average annual profit 900 Initial cash outlay 10,000 A. R. R. 9% (Return on capital employed) Machine B £ 2,000 330 10,000 3.3% Machine C £ 5,000 830 10,000 8.3%

Samantha:
‡ Interesting, but now seems we should purchase Machine A, ‡ Machine A least favoured under Payback Method.

John:
‡ Unadjusted rate of return method also does not take into account timing of cash flows. Also, obvious dangers in working on average basis of whole life of projects.

Samantha:
‡ Is there method dealing with timing of cash flows? ‡ Also: £1,000 received at end of year 1 with Machine A given same weight in second method as £1,000 received at end of year 6 with Machine C. ‡ Prefer money today rather than money tomorrow, ‡ Any sensible method of evaluating capital projects should take this into account.

3
John:

DISCOUNTED CASH FLOW
Discounted Cash Flow method covers satisfactorily Samantha's objections to first two methods. Basic problem: we have immediate cash outflow to purchase machine, and future cash inflows could arise. Samantha prefers to calculate in present values: she wishes to express future cash inflows in present values. £1,000 receivable in one year¶s time is worth less than £1,000 receivable now, What is value of £1,000 receivable in one year's time?

Samantha:
Depends upon rate of interest used, Using 10% rate of interest, £1,000 receivable in one year¶s time is worth £909 now. The £909 could be invested at 10%, which would represent a total of £1,000 in one year¶s time. ‡ Confused by the ranking of the machines under first two methods. ‡ ‡ ‡ ‡

Machine Shop Foreman:
‡ We've got another breakdown on our hands with that old machine.

Ranking
Payback Unadjusted rate of return (ARR)
Machine A Machine C Machine B

Ranking

1 2 3

Machine B Machine C Machine A

Required
1 Using a 10% discount rate, complete following table representing present value of £100 receivable at end of a number of years. (Present day) YEAR 0 £1,000 YEAR 1 £ 909 YEAR 2 YEAR 3 YEAR 4 2 Evaluate the capital expenditure decision, using discounted cash flow method (DCF).

2
John:

A capital expenditure decision (2)
Essence of capital expenditure decisions: We are committing resources for long period of time. Worthwhile taking long look at problem because, once committed resources, will not be easy to retract. Need to regard capital expenditure planning as a major management problem. Company should organise to deal with planning and control of expenditure. Discounted Cash Flow (DCF):

Two main ways of using DCF technique: Net Present Value and Yield or Internal Rate of Return methods.

1

NET PRESENT VALUE METHOD (NPV)
Required minimum earnings rate is assumed, and present value of a project is calculated by discounting all future cash flows at this required earnings rate. If total of these exceeds initial outflow, then project is giving a return greater than the required earnings rate. To compare two or more projects, accountant can compute the profitability index (PI) of each project by: Net present value (NPV) of returns divided by NPV of outlays Project with highest PI is preferred.

Calculation of NPV
C A SH O U T FL O W Initia l outla y C A SH I N FL O W 10% D is c o unt Rate Y ear 0 1 2 3 4 5 6 MACHINE A MACHINE B Pr e s e nt Pr e s e nt Value Value £ £ £ £ £1 10,000 10,000 10,000 10,000 £0.909 1,000 909 4,0 00 3,636 0.826 0.751 0.683 0.621 0.564 2,000 3,000 3,000 3,000 3,400 15,400 PR O FI T A B I L I T Y I N D E X 1,652 2,253 2,049 1,863 1,918 10,644 10,644 10,000 = 1.0 6 3,0 00 3,0 00 1,0 00 5 00 5 00 12,000 2,478 2,253 683 310 282 9,642 9,6 42 10,000 = 0.9 6 MACHINE C Pr e s e nt Value £ £ 10 ,00 0 10,000 3,000 2,727 3,000 3,000 3,000 2,000 1,000 15 ,00 0 2,478 2,253 2,049 1,242 564 11.313 11,313 10,000 = 1 .13

John:
‡ Assuming a required earnings rate of 10%, Machines A and C would give a return greater than 10%. ‡ Machine B, however, failed to meet required earnings rate of 10% ‡ In comparing Machines A and C, profitability index of C is greater than profitability index of A. ‡ Machine C best meets required earnings rate and is one to prefer.

Samantha:
‡ Possible to separately state the return from each project?

John:
‡ This is the objective of the yield or internal rate of return (IRR) method.

2

YIELD OR INTERNAL RATE OF RETURN (IRR) METHOD
All future cash flows from a project are discounted at a variety of discount rates Until, by trial and error, the rate is found at which: the present value of outlays and returns are equal.

John:
He had calculated the yield of each project as follows :

Machine: Yield or IRR

A 12%

B 8%

C 15%

This rate of return can be shown in the form of a repayment statement from a bank or building society, a form with which many managers are familiar.

REPAYMENT STATEMENT-MACHINE C
Year Net investment Interest Cash inflow Reduction at start of year at 15% of investment

1 2 3 4 5 6

£ 10,000 8,500 6,775 4,791 2,510 886

£ 1,500 1,275 1,016 719 376 114* 5,000

£ 3,000 3,000 3,000 3,000 2,000 1,000 15,000

£ 1,500 1,725 1,984 2,281 1,624 868 10,000

Samantha:
‡ It might not be possible to re-invest the earnings from Machine C at 15%?

John:
This is a problem. Also, not always one unique rate of return. May be more than one rate of return for the same project. Also the difficulty in estimating the life of the project The IRRs would also have been different if we had assumed a seven-year life instead of a six-year life for the machine. ‡ In NPV method, an obvious difficulty lies in deciding what interest rate should be used for discounting. ‡ Should minimum required earnings rate be borrowing rate or the lending rate? ‡ Allowance needed for period in which receipts are received: money received in (say) third year of a project may be worth more, due to a shortage of cash, than an equivalent amount of money received in the second year. ‡ ‡ ‡ ‡

John: ‡ Despite these problems, there is real benefit in evaluating the project on a Discounted Cash Flow basis. ‡ Now need to demonstrate the significant effects of taxation on investment decisions, ‡ We need to rework the examples on an after-tax basis. ‡ However, not today«

Required:
1 Compare Net Present Value Method with Yield Method, considering their application to differing projects with differing capital sums to be invested What should be the minimum required earnings rate of projects for the company?

2

Any Questions ?

Powerpoint presentation prepared by M C Pratt, St Martin·s College, from:
Hardy Heating Co. Ltd. by G. Ray and J Smith, published by the BBC, 1968 NOTE: Copyright of content in all slides is assumed to be retained by the BBC or by G. Ray and J Smith. As far as slide content is concerned, the only exception to this is where amendments or improvements have been made in this presentation which are sufficient for copyright of those amendments or improvements to then pass to M C Pratt. Copyright of this Powerpoint presentation, however, where it does not infringe the above copyright(s), is retained by M C Pratt (© 2003).

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