TOPIC 6: EVALUATING CAPITAL EXPENDITURE

DECISIONS

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LESSON 1: WHAT ARE CAPITAL
EXPENDITURE DECISIONS (CED)

CED are long term investment decisions for a business

Like purchase decisions of PPE(long term assets), enhancement
decisions, replacement decisions or change of technology
(competitive decisions)
Also known as Capital Budgeting or Capital Investment
decisions

Why important Capital Expenditure Decisions (CED)

Many would be one-of investment but concerns large
sums/costly
Resources limitation (finance) cannot take up multiple projects
Focus on specific projects or programs

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LESSON 1: CED & APPROVAL
PROCESS

CED are on the basis of approval of senior

management
Follows a controlled process and with strict
authorisation
Business/companies may have their
regulations/committees for investment decisions
However in theory we follow the 6 step model:

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TECHNIQUES FOR ANALYSING
CAPITAL PROJECTS

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 Let’s look at an example to explain the techniques:

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USE THE TECHNIQUES TO
ANALYSE THIS PROJECT…

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 PAYBACK METHOD WITH UNEVEN
CFS..
FNU intends to invest in a plant costing $10,000. The
required rate of return is 15%The expected NCFs
generated by the plant is as follows:

What is the Payback Period for this project. Use cumulative

CFS.

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DECISIONS USING PB
METHOD
Accept/ Reject Criterion
Independent Projects – accept if PB falls within
the maximum acceptable payback period
provided there are no constraints as to the
maximum amounts of funds available for capital
investments.
Mutually Exclusive Projects– accept project
with the shortest PB

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PAYBACK: THE PROS AND
CONS
Two drawbacks
 Ignores the time value of money
 Ignores cash flows beyond the payback period

Widely used for several reasons

 Simplicity

 Useful for screening investment projects

 Cash shortages may encourage short payback

 Provides some insight as to the risk of a project

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 ACCOUNTING RATE OF
RETURN
Focuses on the incremental accounting profit less
incremental expenses that results from a project
over the years.
Formula for Accounting rate of Return:

Or

Accounting rate of return is, effectively, an

average annual ROI for an individual project.
Therefore managers may either use *annual or
average net profit.
Decision: the higher the ARR the better for the project.

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ACCOUNTING RATE OF RETURN:
PROS AND CONS
Advantages of the accounting rate of return
method
 Simple way to screen investment projects

 Consistent with financial accounting methods

 Consistent with profit-based performance evaluation

 Considers the entire life of the project

Major disadvantage
 Ignores the time value of money

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DISCOUNTED CASH FLOW
ANALYSIS…NPV &IRR
A technique used in investment decisions to take account of the time
value of money
The formula for calculating …NPV = (initial cost) + Sum of the PV of
CFs

Accept – Reject decisions with NPV:

 NPV > 0 --- accept or +ve projects accept
 NPV < 0 --- reject or –ve projects reject
 Mutually exclusive Projects--- accept the project which yields the highest
positive NPV.

 Internal rate of return (IRR) method…. Read additional notes

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Example ..NPV case analysis….slide 9.

Accept as NPV is positive $33 855.

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Example 2 ..refer to FNU investment of $10 000 ..slide 11

Calculate NPV = -CF0 + CF1_ + CF2_ + CF3_ + CFn_

(1+k)1 (1+k)2 (1+k)3 (1+k)n
= (10,000) + 1,500 + 2,000 + 3,500 + 2,000 + 2,000 + 2,000
(1+0.15)1 (1+0.15)2 (1+0.15)3 (1+0.15)4 (1+0.15)5 (1+0.15)6
= -10,000 + 8120.45
NPV = -$1879.55
Thus quantitatively decision: Reject the project since NPV is < 0 (ie negative)

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INTERNAL RATE OF RETURN
(IRR)
IRR is the time adjusted rate of return, where expected inflows
= expected outflows.
***IRR is the discount rate at which the NPV of CFs =
Zero

Formula to Calculate
n
the IRR
Ct
p n
t 1 (1  r )

Where p = initial outlay

Ct = net cash flow generated by the project in period t
n = life of the project
r = the internal rate of return
DECISION:
If IRR (discount rate) is greater than the required rate
of return, the project is acceptable on financial grounds
or safe to invest.
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For IRR..Check @ 10%, NPV= 33855, 11%, NPV=16 634,
12%, NPV=0

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For Even cash flows (Annuity) can use table 4.

Retry with table 4:

NPV @10% = (659715)+ (183000*3.790)=33855
NPV@12% = (-659715)+(183000*3.605)= 0
So we can say that IRR is 12% - acceptable
project.
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COMPARING THE NPV AND IRR
METHODS
NPV has many advantages over IRR
 Easier to calculate manually
 Adjustments for risk possible under NPV
 NPV will always yield only one answer
 NPV overcomes unrealistic reinvestment assumption
required for IRR

* both involves the time value of money(risk and interest

rates)

In general, the NPV technique is usually regarded as

superior to the IRR technique when evaluating capital
investment proposals
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CED – USING
PROFITABILITY INDEX
* Managers sometimes apply in ranking investment
proposals is called the Profitability Index (or excess
present value index).
Formula: Profitability index

Example. Check ..Slide 17 purchase of CT scanner

 Calculate the PV of $183000 cost savings for 5 years
Total sum of PV = 693 570/659 715 = 1.05
PI

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COMPARING TWO ALTERNATIVE
INVESTMENT PROJECTS
Decisions when dealing with Multiple
projects/alternative projects:
You can summarise your results:
With PB – the shortest PB period is the best
With NPVs – the highest the better
With ARR – the higher the better
PI – anything above 1would be acceptable, as
1:1 would be breakeven.
With IRR- IRR should be greater than the RRR
This was quantitatively based decisions, qualitative
decisions can be otherwise.

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