UCL SCHOOL OF MANAGEMENT

MAFE
LECTURE 6

Capital Expenditure

Elliot Guner

This Lecture draws upon Core Text book Chapter 6

The content of the slides has been developed by A
Parkinson & Elliot Guner
CAPEX
Lecture 6: Learning Outcomes
By the end of this lecture you will be able to:

Explain the nature and importance of investment decision

making.

Recognise the role of incremental cash flows within CAPEX

calculations and decisions.

Identify and apply the main investment appraisal techniques

found in practice: ARR, Payback, NPV, Profitability Index
(PI).

Assess longer term investment opportunities.

2
HEALTH WARNING!!!

• It is assumed that, as requested, you have

accessed and worked through i) the Vid-cast on
Moodle relating to this lecture.

• The Vid-cast looked at:

- the ideas and applications of payback, net
present value through discounted cash flow
calculations;
- the nature of cost of capital and its role in
NPV calculations.

3
Incremental cash flows within CAPEX
• One technique – Accounting Rate of
Return (ARR), is profit-based
• Others are cash-based
• Cash-based = using Incremental Cash
Flows
• Remember a relevant value is one
which represents, as a result of going
ahead with a proposal:
 an additional cash inflow
 an additional cash outflow
 an existing cash inflow lost
 an existing or potential cash outflow saved
or avoided
4
 Invest Limited: Cash Payback, Cash NPV,
Profit ARR, with £100,000 investment in
Year
equipment Incremental Cash Flow
£
0 (100,000)
1 36,000
2 60,000
3 42,000
4 10,000
- Assume equipment has no residual
value at the end of its life
- Equipment depreciation is straight-line
over 4 years = £25,000 annually
- Cost of capital is 15% rate (discount
factors given) 5
ARR Calculation (profit-based)
(financial figures in £000)

Assume depreciation is straight line over: 4 years

Thus annual depreciation is investment in equipment is: 25
Deduct from operational cash flows to obtain forecast annual profits:
Annual cash flows -100 36 60 42 10
less Depreciation -25 -25 -25 -25
Operating Profit 11 35 17 -15

Average Profit 12 Average Profit 12

Average Investment -50 OR Initial Investment -100
ARR 24% ARR 12%

6
PAYBACK Calculation (cash-based)
(financial figures in £000)
All in £000
Item Year 0 1 2 3 4
Investment -100
Net cash flows 36 60 42 10
Annual cash flows -100 36 60 42 10
Cumulative -100 -64 -4
Payback is in Year 2
64 60
3.07 years

7
 NPV Calculation (cash-based)
(financial figures in £000)

Annual cash flows -100 36 60 42 10

Discount factor 15% 1 0.870 0.756 0.658 0.572
PV -100 31.32 45.36 27.636 5.72
NPV 10.036

8
Why NPV is superior to ARR and Pay Back
NPV is a better method of appraising investment
opportunities than either ARR or PB because it fully
addresses each of the following:

The timing of the cash flows

The whole of the relevant cash flows

The objectives of the business INCREASING OWNER WEALTH

9
 WORK!!
Exercise 6.1: Mylo Limited in text book
• In this question there are no cash flows given, only
the expected profits.
• To convert the profit into cash flow, add back the
annual depreciation to the expected annual
operating profits.
• The annual depreciation charges are:
Project 1 Project 2
Investment in plant £100 £60
Anticipated residual value£ 7 £ 6
Anticipated net investment £ 93 £ 54
Life of project 3 years 3 years
Annual straight
line depreciation £ 31 £ 18
• Each depreciation figure is added back to anticipated
annual operating profits.MAD
10 L5
 Exercise 6.1: Mylo Limited in text book
Payback and NPV - both cash-based
Half of you do Project , and half do Project
2 6.1 MYLO LIMITED - CALCULATING PAYBACK, and NPV
A & M QUESTION
DISCOUNTING AT COST OF CAPITAL OF 10% ALL FIGURES IN £000s
NOTE THAT THE PROFIT NEEDS TO BE CONVERTED TO 0 1 2 3
CASH BY ADDING BACK THE NON CASH ITEM DEPRECIATION
NET PROFIT/(LOSS) 29 -1 2
ADD BACK DEPRECIATION 31 31 31
CASH FLOWS (INCLUDING INVESTMENT IN PROJ ECT AT TIME ZERO) -100
RESIDUAL VALUE AT END OF PROJ ECT 7
INCREMENTAL CASH FLOWS -100 60 30 40
CUMULATIVE CASH SHORTFALL AT END OF EACH YEAR -100 -40 -10 30
PAYBACK IS in 3RD YEAR - 2.25 YRS (BEING 1 YR x 10/40)
DISCOUNT FACTOR @ 10% APPLIED TO CASH FLOWS 1 0.909 0.826 0.751
PRESENT VALUES -100.00 54.54 24.78 30.04
NPV 9.36

11
 Internal Rate of Return (IRR)
The internal rate of return is the
discount rate, which, when
Internal rate of applied to the future cash flows
return (IRR) of a project, will produce an
NPV of precisely zero.

• The discount factor used in the initial investment appraisal may, for
a whole variety of reasons, change during the operational life.
• This may be because the risk associated with the project changes,
interest rates may change, shareholders may change their minds
about expectations.
• If the discount rate were to increase, the NPV would decrease.
• It thus makes sense to calculate in advance the discount factor at
which the NPV is zero to help in making the investment decision.

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Internal Rate of Return (IRR)
• Imagine you want to undertake a 1 year project but you can only raise £50,000 funds
from a bank overdraft at an Interest Rate of 10%

• You identify all the relevant cash flows, apply the discount rate and (let’s imagine)
you calculate the NPV to be £20,000 positive (hooray!)

• But you are worried that interest rates might increase – and as a consequence your
interest rate will increase too, the cost of capital will increase, leading to a lower NPV

• If interest rate increases continue to occur, your NPV would get lower and lower until
it hits zero – after that it would not be worthwhile undertaking the project as the NPV
would be negative

• The discount rate applied at the point when the NPV is zero is the IRR

• It makes sense to calculate it in advance if you are worried about your cost of capital
changing

13
Internal Rate of Return (IRR)
Imagined figures
Cost of Capital % NPV £

10 20,000
11 15,000
12 10,000
13 5,000
14 0
IRR is at 14%

• This is a difference of 4% (in nominal figures) between existing cost of capital and the IRR

• What would be great would be to have a BIG gap between the existing cost of capital and the
IRR as that would mean less risk

• Organisations set a pre-determined IRR % rate (hurdle rate) and the NPV must still be
positive above that % rate

14
 IRR – the calculation by hand
• Investment proposal is to buy a machine for
£80,000.
• This will save £20,000 annually for 5 years and
will have a resale value of £10,000 at the end
of year 5
• To calculate the IRR a ‘trial and error’ approach
is adopted.
• Assume Cost of Capital is 9%.
• Calculate NPV at existing Cost of Capital % – it
should be positive

• Select a higher Cost of Capital % and calculate

NPV

• Keep doing so until you arrive a negative NPV

• Then apply an interpolation

15 calculation to find the
% at which the NPV is zero
 IRR – the calculation by hand
• Assume Cost of Capital is 9%.
• The NPV at 9% is calculated.
• Using the forecast figures this works out + £4,300 (honest!!).
• Using 12% the NPV is -£2,100 (again, honest).
• The IRR is clearly somewhere in between.
• By interpolation we calculate:

• THE % SPREAD IS 3% (9% to 12%) AND NPV of ZERO IS SOMEWHERE ALONG THAT SPREAD
• THE MATHEMATICAL SPREAD IS 6,400 (+4,300 to -2,100) AND NPV OF ZERO IS SOMEWHERE
ALONG THAT SPREAD
• WE LINK THE TWO
IRR = 12% - 9% = 3% multiplied by:
4,300
the spread between +4,300 and -2,100 (spread is 6,400)

= 4,300 = 0.67 x 3% = 2.02% + 9% original % = 11.02% IRR

6,400

16
 Back to our original data (not Mylo Limited from
book)
with £100,000 investment in Equipment, 4 year
project
Annual cash flows -100 36 60 42 10
Discount factor 15% 1 0.870 0.756 0.658 0.572
PV -100 31.32 45.36 27.636 5.72
NPV 10.036

Let’s see what NPV is using 25%

17
IRR Calculation
FOR INTERNAL RATE OF RETURN TRY USING 25%
Annual cash flows -100 36 60 42 10
Discount factor 20% 1 0.800 0.640 0.512 0.410
PV -100 28.8 38.4 21.504 4.1
NPV -7.196

ORIGINAL NPV AT 15% 10.036

NPV AT 25% -7.196
SPREAD OF NPVs 17.232

ORIGINAL NPV 10.036

SPREAD OF NPVs 17.232
ORIGINAL/SPREAD 0.582405
GAP BETWEEN DISCOUNT RATES 10%
ORIGINAL/SPREAD X GAP 5.82%
PLUS ORIGINAL DISCOUNT RATE 15%
IRR 20.82%

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 Exercise 6.1: Mylo Limited IRR
IRR PROJECT 1 USING 20% TO CALCULATE NPV, IN £000 0 1 2 3
INCREMENTAL CASH FLOWS -100 60 30 40
DISCOUNT FACTOR @ 20% 1 0.833 0.694 0.539
PRESENT VALUES -100 49.98 20.82 21.56
NPV -7.64
IRR INTERPOLATION
CALCULATION
9.36 9.36 #DIV/0! 10% SPREAD
IIR% PROJECT 1 = #DIV/0! 15.51%

IRR PROJECT 1 USING 20% TO CALCULATE NPV, IN £000 0 1 2 3

INCREMENTAL CASH FLOWS -60 36 16 28
DISCOUNT FACTOR @ 20% 1 0.833 0.694 0.539
PRESENT VALUES -60 29.99 11.10 15.09
NPV -3.816
IRR INTERPOLATION
CALCULATION
6.97 6.97 0.65 10% SPREAD
6.97 PLUS - 3.816 10.78 6.46 16.46%
IRR PROJECT 2 16.46%

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Summary for Mylo Limited

Project 1 Project 2

Payback in years 2.25 2.29

NPV £000 £9.36 £6.97

IRR % 15.51 16.46

Oh dear - what to do?

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Profitability Index (PI): cash (not profit)
based
Find the NPV for a project
Identify the initial investment(s) at time zero

Divide NPV by Initial Investments

Project 1Project 2
NPV £000 £9.36 £6.97
Time Zero Investment(s) £000 £100 £60

PI ‘return’ 9.36% 11.61%

• Project 1 has the higher ‘return’ along with the

higher NPV
• Payback is about the same
• If IRR is above hurdle rate….go for Project 1
21
 Why NPV is superior to ARR and Pay Back
NPV is a better method of appraising investment
opportunities than either ARR or PB because it fully
addresses each of the following:

The timing of the cash flows

The whole of the relevant cash flows

The objectives of the business INCREASING OWNER WEALTH

22
 Getting Estimates Right…or Wrong!
McKinsey survey 2007 2,500 senior managers
worldwide

• General opinion: estimates often too optimistic.

• Sales forecasts over-estimated in 50% of projects.

• Sales forecasts under-estimated in 20% of projects.

• 19% of projects which had gone ahead should not

have.

• 31% of projects which had been rejected should have

been accepted.

• Many managers felt that where existing projects were

not performing well, too much money was thrown at
them in an attempt to put23them right.
 To Try at Home (answers at the back)!
Exercise 6.2 Page 230
Exercise6.2
Arkwright Mills
0 1 2 3 4 5 6
£m £m £m £m £m £m £m
Investment -1
Operating profit 0.2 0.3 0.3 0.3 0.3
Add back depreciation assume straight line 0.2 0.2 0.2 0.2 0.2
Corporation tax @ 20% of profits -0.1 -0.15 -0.15 -0.15 -0.15
Working capital -0.6 0.6
Cashflows -1.6 0.4 0.4 0.35 0.35 0.95 -0.15
Cumulative cash flows -1.6 -1.2 -0.8 -0.45 -0.1 0.85
Payback 4.11 years

Cash flows -1.6 0.4 0.4 0.35 0.35 0.95 -0.15

Discount @ 10% 1 0.909 0.826 0.751 0.683 0.621 0.564
Presentvalues -1.6 0.364 0.330 0.263 0.239 0.590 -0.085
NPV 0.101

24
And Now…

In your book, attempt Ex 6.5 C.George

(Controls) Limited

Many of the incremental cash flows are easily

identified.
There are three key challenges:
 Calculating the savings in variable costs (which
as savings are relevant costs and thus
incremental cash flows)
 Any values to be included in the incremental
cash flows connected to the existing
equipment.
25
 The treatment of the working capital.
CAPEX: MORE WORK
Aggregate Inc
Aggregate Ltd has recently received an invitation to produce a new cement
compound for supply to another cement manufacturer. The invitation is to produce
15,000 kg each year for the next three years at a price of £42 per kg.

The following information has been collected which will help the directors to reach a
decision on whether to accept the invitation or not:

- New plant costing £200,000 will be purchased and paid for before production
begins. This will have a residual value of £10,000 at the end of the third year.
If the plant is acquired, the business will follow its normal practice of
depreciating it on a straight-line basis in the annual financial accounts.
- Ten new workers will be taken on for the duration of production. Recruitment
costs, payable before production starts, will total £20,000. The workers will be
paid compensation for being made redundant at the rate of £3,000 per
worker, payable at the end of the production period. During the production
period the workers will be paid £200,000 in total each year.
CAPEX: MORE WORK
Aggregate Inc
- Production of the new cement compound will be charged with a share of the
business’s overheads totalling £55,000 in each of the three years. It is
estimated that the production of the new cement compound will result in
additional total overhead expenditure of £18,000 in each of the three years.
- Production will require the use of an ingredient, known as X, at the rate of
6,000 kg each year. The business already has inventories of 4,000 kg. This
was originally bought for £15 per kg. This was purchased for a previous
contract that had to be abandoned. If the existing inventory of X is not used in
production of the new compound there is no other use for it and it will be
disposed of immediately. It will cost £2 per kg to dispose of X. The cost of new
X is £20 per kg.
- Production will also require the use of 9,000 kg each year of another
ingredient, known as Y. The business already has 9,000 kg in inventories,
which cost £25 per kg. Recently the buying price has dropped to £20 per kg.
Y is used in large quantities on a number of the business’s current products,
all of which will continue to be produced.
- The cost of capital is 12%: Time Zero = 1, Year 1 = .893, Year 2 = .797, and
Year 3 = .712.
- The above data was discovered by a consultant last year for an agreed fee of
£2,000. The payment has not yet been made but will be made irrespective of
whether the project goes ahead or not.

Assume cash flows in Years 1, 2 and 3 occur at the end of each year.

Required: Calculate the NPV.

CAPEX: MORE WORK
Aggregate Inc
Figures in 0 1 2 3
£000
Sales 630 630 630
Plant -200 10
And Now…Work Outside the Lecture
In advance of Lecture 7:
TEACHING WEEK 30
Lecture 8: Budgeting and financial planning
The nature and purpose of budgeting
The budget setting process
Incremental budgeting
Zero-base budgeting
Activity-based budgeting
Preparing cash budgets

Core Reading: Chapter 7 + No Vidcast for

Lecture 8
COMPLETE THE ESSENTIAL ACTIVITIES
29 & SELF-