Module 1

-Karishma Chaudhary
 Capital Expenditure decision
OBJECTIVE
a) meaning, nature and importance of capital
expenditure decisions; and
b) criteria of capital expenditure decisions.
The Capital Budgeting Process
 INTRODUCTION
The efficient allocation of funds is among the main
functions of financial management.
Allocation of funds means investment of funds in
assets or activities. It is also called investment
decision because we have to select the assets in
which investment has to be made. These assets
can be classified into two parts :-
i) Short-term or Current Assets.
ii) Long-term or Fixed Assets.
 The Typical Capital Budgeting Process
• Phase I: The firm’s management identifies
promising investment opportunities.
• Phase II: The value creating potential of various
opportunities are thoroughly evaluated.

• So the goal is to identify promising opportunities

and select those that will create the most value
for the firm’s common stockholders.
 What Are the Sources of Good Investment
Projects?
• It is not easy to find profitable investment
opportunities in competitive markets.

• Good investments are most likely to be found

in markets that are less competitive where
barriers to new entrants are sufficiently high
to keep out would-be competitors.
 MEANING AND FEATURES OF CAPITAL EXPENDITURE OR
BUDGETING DECISIONS

• A capital budgeting decisions may be defined as the firm’s

decision to invest its current funds most efficiently in the long-
term assets in anticipation of an expected flow of benefits over a
series of years.
• In other words, “capital budgeting is used to evaluate the
expenditure decisions such as acquisition of fixed assets,
changes in old assets and their replacement.”
• Activities such as change in the method of sales distribution or
undertaking an advertisement campaign or a research and
development programme have long-term implication for the
firm’s expenditure and benefits and therefore, they may also be
evaluated as investment decisions.
 Features of Capital Budgeting Decisions

- Investment of fund is made in long-term assets.

- The exchange of current funds for future benefits.
- Future profits accrue to the firm over several years.
- These decisions are more risky.
It is significant to emphasize that expenditure and benefits of an investment
should be measured in cash.
In the investment analysis, it is cash flow which is important, not the accounting
profit. It may also be pointed out that investment decisions affect the firm’s
value. The firm’s value will increase if investment are profitable.

Investment should be evaluated on the basis of a criteria on which it is compatible

with the objective of the shareholder’s wealth maximization.
An investment will add to the shareholder’s wealth if it yields benefits in excess
of the minimum benefits as per the opportunity cost of capital.
IMPORTANCE OF CAPITAL EXPENDITURE DECISION

Investment decisions require special attention because of the following reasons :

1. Growth :- The effects of investment decisions extend into the future and have to
endured for a longer period than the consequences of the current operating
expenditure. A firm’s decisions to invest in long-term assets has a decisive influence on
the rate direction of its growth. A wrong decisions can prove disastrous for the
continued survival of the firm.
2. Risk :- A long-term commitment of funds may also change the risk complexity of the
firm. If the adoption of an investment increases average gain but causes frequent
fluctuations in its earnings, the firm will become very risky.
3. Funding :- Investment decisions generally involve large amount of funds. Funds are
scarce resource in our country. Hence the capital budgeting decision is very important.
4. Irreversibility :- Most investment decisions are irreversible
5. Complexity :- Investment decisions are among the firm’s most difficult decisions. They
are concerned with assessment of future events which are difficult to predict. It is really
a complex problem to correctly estimate the future cash flow ofinvestment
 Objectives of Capital Budgeting Decision

Capital budgeting helps in selection of profitable projects. A company should

have system for estimating cash flow of projects.
A multidisciplinary team of managers should be assigned the task of developing
cash flow estimates.
Once cash flow have been estimated, projects should be evaluated to
determine their profitability.
Evaluations criteria chosen should correctly rank the projects. Once the
projects have been selected they should be monitored and controlled. Proper
authority should exist for capital spending.
Critical projects involving large sum of money may be supervised by the top
management. A company should have a sound capital budgeting and
reporting system for this purpose. Based on the comparison of actual and
expected performance, projects should be reappraised and remedial action
should be taken.
 KINDS OF CAPITAL EXPENDITURE DECISIONS

Expansion and diversification

A company may add capacity to its existing product lines to expand existing operations.
For example, a fertilizer company may increase its plant capacity to manufacture in
more areas.
Diversification of a existing business require investment in new product and a new kind of production
activity within the firm. Investment in existing or new products may also be called as revenue-expansion
investment.

Replacement and modernisation

The main objective of modernisation and replacement is to improve operating efficiency and reduce costs.
Assets become out dated and obsolete as a result of technological changes . The firm must decide to replace
those assets with new assets that operate more economically. If a cement company change from semi-
automatic drying equipment to fully automatic drying equipment to fully automatic drying equipment, it is an
example of modernisation and replacement. Yet an other useful way to classify investment is as
follow :
-Mutually exclusive investments
-Independent investments
- Contingent investments
Mutually exclusive investment
Mutually exclusive investment serve the same purpose and compete with each other. If one
investment is selected other will have to be rejected. A company may, for example, either use
more labour-intensive, semi-automatic machine or employ a more capital intensive, highly
machine for production.
Independent Investment
Independent investment serve different purposes and do not compete with each other.
For example a heavy engineering company may be considering expansion of its plant capacity to
manufacture additional excavators and adding new production facilities to manufacture a new
product - Light commercial vehicles. Depending on their profitability and availability of funds,
the company can undertake both investment.

Contingent Investment
Contingent investment are dependent projects. The choice of one investment necessitates under
taking one or more other investments. For example, if a company decided to build a factory in a
remote backward area, it may have to invest in houses, road, hospitals, schools etc. The total
expenditure will be treated as one single investment.
 CAPITAL BUDGETING PROCESS
Capital budgeting is a complex process which may be divided into five broad
phases.
Planning
The planning phase of a firm’s capital budgeting process is concerned with the articulation of its
broad strategy and the generation and preliminary screening of project proposals. This provides
the framework which shapes, guides and circumscribes the identification of individual project
opportunities.

Analysis
The focus of this phase of capital budgeting is on gathering, preparing and summarising relevant
information about various project proposals which are being considered for inclusion in the
capital budget. Under this a detail analysis of the marketing, technical, economic and ecological
aspects in undertaken.

Selection
Project would be selected in the order in which they are ranked and cut off point would be
reached when the cumulative total cost of the projects become equal to the size of the plan
funds. A wide range of appraisal criteria have been suggested for selection of a project. They
are divided into two categories viz, non-discounting criteria and discounting criteria.
CRITERIA OF CAPITAL BUDGETING

There are two broad criteria of capital budgeting :

1. Non discounting criteria
The method of capital budgeting are the techniques which are used
to make comparative evaluation of profitability of investment.
The non-discounting methods of capital are as follows :
• Pay back period method (PBP)
• Accounting rate of return method (ARR)
2. Discounting Criteria
• Net present value method (NPV)
• Internal rate of return method (IRR)
• profitability index method (PVI)
 FA and EA
• While financial analysis examines the
adequacy of the returns of a project,
economic analysis of a project measures its
effects on the national economy.
• Financial analysis and economic analysis are
complementary. If a project is not financially
sustainable, economic benefits will not be
realized.
 Non-revenue Earning Projects
Non-revenue earning projects are not subjected to a financial viability test
because by definition they do not have a positive cash flow stream.
It is difficult to quantify monetary benefits of projects in sectors like
health, education, water supply and sanitation, etc.
To this regards two evaluation approaches are popular, namely,
costeffectiveness analysis and cost-utility analysis.
Where attaching monetary values to any outcome is untenable a cost-
minimization approach is commonly used, whereby the option with the
least cost is selected, given the identical outcome of all alternative options.
This is the cost-effectiveness analysis. The cost-utility analysis also
measures costs per unit of an outcome, but the outcome effectiveness is
further measured in terms of the quality of the benefits and therefore the
outcome effectiveness reflects both quantity and quality.
Capital Expenditure Data for Bennett
Company

10-23
Figure 10.1 Bennett Company’s
Projects A and B

10-24
 Payback Period
The payback method is the amount of time required
for a firm to recover its initial investment in a project, as
calculated from cash inflows.
Decision criteria:
– The length of the maximum acceptable payback period is
determined by management.
– If the payback period is less than the maximum acceptable
payback period, accept the project.
– If the payback period is greater than the maximum
acceptable payback period, reject the project.

10-25
 Payback Period (cont.)
We can calculate the payback period for Bennett Company’s
projects A and B using the data in Table 10.1.
– For project A, which is an annuity, the payback period is 3.0 years
($42,000 initial investment ÷ $14,000 annual cash inflow).
– Because project B generates a mixed stream of cash inflows, the
calculation of its payback period is not as clear-cut.
• In year 1, the firm will recover $28,000 of its $45,000 initial investment.
• By the end of year 2, $40,000 ($28,000 from year 1 + $12,000 from year
2) will have been recovered.
• At the end of year 3, $50,000 will have been recovered.
• Only 50% of the year-3 cash inflow of $10,000 is needed to complete the
payback of the initial $45,000.
– The payback period for project B is therefore 2.5 years (2 years + 50%
of year 3).

10-26
 Payback Period: Pros and Cons of
Payback Analysis
• The payback method is widely used by large firms to evaluate
small projects and by small firms to evaluate most projects.
• Its popularity results from its computational simplicity and
intuitive appeal.
• By measuring how quickly the firm recovers its initial
investment, the payback period also gives implicit
consideration to the timing of cash flows and therefore to the
time value of money.
• Because it can be viewed as a measure of risk exposure, many
firms use the payback period as a decision criterion or as a
supplement to other decision techniques.

10-27
 Payback Period: Pros and Cons of
Payback Analysis (cont.)

• The major weakness of the payback period is that the appropriate

payback period is merely a subjectively determined number.
– It cannot be specified in light of the wealth maximization goal because it is
not based on discounting cash flows to determine whether they add to the
firm’s value.
• A second weakness is that this approach fails to take fully into
account the time factor in the value of money.
• A third weakness of payback is its failure to recognize cash flows
that occur after the payback period.

10-28
Calculation of NPVs for Bennett Company’s Capital
Expenditure Alternatives

10-29
 Internal Rate of Return (IRR)
The Internal Rate of Return (IRR) is a sophisticated
capital budgeting technique; the discount rate that
equates the NPV of an investment opportunity with $0
(because the present value of cash inflows equals the
initial investment); it is the rate of return that the firm
will earn if it invests in the project and receives the
given cash inflows.

10-30
 Internal Rate of Return (IRR)
Decision criteria:
– If the IRR is greater than the cost of capital, accept the
project.
– If the IRR is less than the cost of capital, reject the project.

These criteria guarantee that the firm will earn at least

its required return. Such an outcome should increase the
market value of the firm and, therefore, the wealth of its
owners.

10-31
Figure 10.3a Calculation of IRRs for Bennett Company’s
Capital Expenditure Alternatives

10-32
Figure 10.3 Calculation of IRRs for Bennett Company’s
Capital Expenditure Alternatives

10-33
 Internal Rate of Return (IRR):
Calculating the IRR (cont.)
• To find the IRR using the preprogrammed function in a
financial calculator, the keystrokes for each project are the
same as those for the NPV calculation, except that the last two
NPV keystrokes (punching I and then NPV) are replaced by a
single IRR keystroke.
• Comparing the IRRs of projects A and B given in Figure 10.3
to Bennett Company’s 10% cost of capital, we can see that
both projects are acceptable because
– IRRA = 19.9% > 10.0% cost of capital
– IRRB = 21.7% > 10.0% cost of capital
• Comparing the two projects’ IRRs, we would prefer project B
over project A because IRRB = 21.7% > IRRA = 19.9%.

10-34
Comparing NPV and IRR Techniques: Timing of
the Cash Flow

Notice how the IRR and NPV methods provide different

preferences for investment options A or B. NPV prefers
Option A while IRR prefers Option B. This has to do
with differences in the timing of cash flows.
– When much of a project’s cash flows arrive early in its life,
the project’s NPV will not be particularly sensitive to the
discount rate.
– On the other hand, the NPV of projects with cash flows that
arrive later will fluctuate more as the discount rate changes.
– The differences in the timing of cash flows between the
two projects does not affect the ranking provided by the
IRR method.

10-35
 Comparing NPV and IRR Techniques: Which
Approach is Better?

On a purely theoretical basis, NPV is the better approach

because:
– NPV measures how much wealth a project creates (or destroys
if the NPV is negative) for shareholders.
– Wide fluctuations in cash flow may cause a project to have
multiple IRRs— such as more than one IRR resulting from a
capital budgeting project with nonconventional cash flow
patterns.
Despite its theoretical superiority, however, financial
managers prefer to use the IRR approach just as often as
the NPV method because of the preference for rates of
return.
10-36
• Discounted Criteria
Under these methods the projected future cash
flows are discounted by a certain rate called
cost of capital. The second main feature of
these methods is that they take into account
all the benefits and costs accruing during the
life time of the project.
Time Value of Money

38
 Future Values
Future Value - Amount to which an investment
will grow after earning interest.

Compound Interest - Interest earned on interest.

Simple Interest - Interest earned only on the

original investment.

39
 The Power of High Discount Rates

1.00 0%

0.75
Present Value of One Dollar ($)

0.5
5%

0.25 10%
15%
20%
0 2 4 6 8 10 12 14 16 18 20 22 24
Periods
40
What is the PV of this uneven cash flow
stream?

0 1 2 3 4
10%

100 300 300 -50

90.91
247.93
225.39
-34.15
530.08 = PV
41
 Solving for PV:
Uneven cash flow stream
• Input cash flows in the calculator’s “CF” register:
– CF0 = 0
– CF1 = 100
– CF2 = 300
– CF3 = 300
– CF4 = -50
• Under NPV, enter I = 10, down arrow, and press CPT
button to get NPV = $530.087. (Here NPV = PV.)

42
Present value
• Present Value
• An organization has limited resources. They cannot execute all the projects that
come their way. They can take only those projects for execution, which are
financially sound for the organization.
• There are various parameters used in making such decisions.
• Some of these terms are present value, net present value; internal rate of return;
payback period; benefit cost ratio; return on investment; and opportunity cost.
• Present value is today’s value of future cash flows. In order to reduce future
cash flows to present values, a “discount factor” has to be applied.
• What this essentially means is, if a project can give a return of say $100 per year,
$200 next year, and $250 the third year, what is the value of all these returns
today? $250 return in the 3rd year will not be the same as $250 today due to
inflation or any other constraint.
 Net Present Value
• The net present value (NPV) is the difference
between the present value of cash inflows and
the cash outflows. NPV estimates the amount
of wealth that the project creates.

• Decision Criteria: Investment projects should

be accepted if the NPV of project is positive
and should be rejected if the NPV is negative.
 Calculating an Investment’s NPV
• The NPV of an investment proposal can be
defined as follows:
 Independent Versus Mutually Exclusive
Investment Projects
• An independent investment project is one
that stands alone and can be undertaken
without influencing the acceptance or
rejection of any other project.

• A mutually exclusive project prevents another

project from being accepted.
 Evaluating an Independent Investment
Opportunity
• It will require two steps:
1. Calculate NPV;
2. Accept the project if NPV is positive and reject if
it is negative.
 Checkpoint 11.1

Calculating the NPV for Project Long

Project Long requires an initial investment of $100,000 and is expected to
generate a cash flow of $70,000 in year one, $30,000 per year in years two
and three, $25,000 in year four, and $10,000 in year 5.
The discount rate (k) appropriate for calculating the NPV of Project Long is 17
percent. Is Project Long a good investment opportunity?
Checkpoint 11.1
Checkpoint 11.1

Step 3 cont.
Checkpoint 11.1
Checkpoint 11.1
 Checkpoint 11.1: Check Yourself

• Saber Electronics provides specialty

manufacturing services to defense contractors
located in the Seattle, WA area. The initial outlay
is $3 million and, management estimates that the
firm might generate cash flows for years one
through five equal to $500,000; $750,000;
$1,500,000; $2,000,000; and $2,000,000. Saber
uses a 20% discount rate for projects of this
type. Is this a good investment opportunity?
 Step 1: Picture the Problem

k=20% 0 1 2 3 4 5
Years
Cash flows -$3M +$0.5M +$0.75M +$1.5M $2M $2M
(in $ millions)
Net
Present
Value =?
 Step 2: Decide on a Solution Strategy
• We need to analyze if this is a good investment
opportunity. We can do that by computing the
Net Present Value (NPV), which requires
computing the present value of all cash flows.

• We can compute the NPV by using a

mathematical formula, a financial calculator or
a spreadsheet.
 Step 3: Solve
• Using Mathematical Formula
 Step 3: Solve (cont.)
• NPV = -$3m + $.5m/(1.2) + $.75m/(1.2)2 + $1.5m/(1.2)3 +
$2m/(1.2)4 + $2m/(1.2)4

• NPV = -$3,000,000 + $416,666.67 + $520,833.30 +

$868,055.60 + $964,506 + $803,755.10
• NPV = $573,817
 Step 3: Solve (cont.)
• Using an Excel Spreadsheet

• NPV = NPV (discount rate, CF1-5 ) + CF0

= NPV(.20, 500000, 750000, 1500000,
2000000,2000000) - 3000000
= $573,817
 Step 4: Analyze
• The project requires an initial investment of
$3,000,000 and generates futures cash flows
that have a present value of $3,573,817.
Consequently, the project cash flows are
$573,817 more than the required investment.
• Since the NPV is positive, the project is an
acceptable project.
 Evaluating Mutually Exclusive Investment
Opportunities
• There are times when a firm must choose the
best project or set of projects from the set of
positive NPV investment opportunities. These
are considered mutually exclusive
opportunities as the firm cannot undertake all
positive NPV projects.
• Other investment criteria
 Profitability Index
• The profitability index (PI) is a cost-benefit
ratio equal to the present value of an
investment’s future cash flows divided by its
initial cost:
 Profitability Index (cont.)
• Decision Criteria:
– If PI is greater than one, it indicates that the
present value of the investment’s future cash
flows exceeds the cost of making the investment
and the investment should be accepted. If PI is
greater than one, the NPV will be positive.
– If PI is less than one, the project should be
rejected. If PI is less than one, the NPV will be
negative.
 Checkpoint 11.3
Calculating the Profitability Index for Project Long
Project Long is expected to provide five years of cash inflows and to
require an initial investment of $100,000. The discount rate that is
appropriate for calculating the PI of Project Long is 17 percent. Is
Project Long a good investment opportunity?
Checkpoint 11.3
Checkpoint 11.3
Checkpoint 11.3
 Checkpoint 11.3: Check Yourself

• PNG Pharmaceuticals is considering an investment

in a new automated materials handling system
that is expected to reduce its drug manufacturing
costs by eliminating much of the waste currently
involved in its specialty drug division. The new
system will require an initial investment of
$50,000 and is expected to provide cash savings
over the next six-year period as shown on next
slide.
 The Problem (cont.)

Year Expected Cash

Flow
0 -$50,000
1 $15,000
2 $8,000
3 $10,000
4 $12,000
5 $14,000
6 $16,000
 Step 1: Picture the Problem

k=10% 0 1 2 3 4 5 6
Years
Cash flows -$50 +$15 +$8 +$10 +$12 +$14 +$16
(in $, thousands)
PI =?
 Step 2: Decide on a Solution Strategy

• The PI for a project is equal to the present

value of the project’s expected cash flows for
years 1-6 divided by the initial outlay.

• PI = PV of expected cash flows ÷ -Initial outlay

 Step 3: Solve
• We can proceed in two steps:

1. Compute PV of expected cash flows by

discounting the cash flows from Year 1 to Year 6
at 10%.
PVt = CFt÷(1.09)t

2. Compute PI
 Step 3: Solve (cont.)
• Step 1: Computing PV of Cash Inflows
Year Expected Cash Present Value at 10%
flow discount rate
1 $15,000 $13,636.36
2 $8,000 $6,611.57
3 $10,000 $7,513.14
4 $12,000 $8,196.16
5 $14,000 $8,692.90
6 $16,000 $9,031.58
NPV of Expected Cash flows, $53,681.72
Years 1-6
 Step 3: Solve (cont.)
• Step 2: Compute the PI

• PI = PV of expected CF1-6 ÷ Initial Outlay

= $53,681.72 ÷ $50,000
= 1.073
 Step 4: Analyze
• PNG Pharmaceuticals requires an initial
investment of $50,000 and provides future
cash flows that have a present value of
$53,681.72. Thus, the future cash flows are
worth 1.073 times the initial investment or PI
is equal to 1.073.
• It is an acceptable project since PI is greater
than 1.
 Internal Rate of Return
• The internal rate of return (IRR) of an
investment is analogous to the yield to
maturity (YTM) of a bond .
• IRR- rate at which NPV become zero
 Internal Rate of Return (cont.)
• Decision Criteria: Accept the project if the IRR
is greater than the discount rate used to
calculate the net present value of the project,
and reject it otherwise.
 Checkpoint 11.4

Calculating the IRR for Project Long

Project Long is expected to provide five years of cash inflows and to
require an initial investment of $100,000. The required rate of return or
discount rate that is appropriate for valuing the cash flows of Project Long
is 17 percent. What is Project Long’s IRR, and is it a good investment
opportunity?
Checkpoint 11.4
Checkpoint 11.4

Step 3 cont.
Checkpoint 11.4

Step 3 cont.
Checkpoint 11.4
Checkpoint 11.4
 Checkpoint 11.4: Check Yourself

• Knowledge Associates is a small consulting

firm in Portland, Oregon, and they are
considering the purchase of a new copying
center for the office that can copy, fax,
and scan documents. The new machine
costs $10,010 to purchase and is expected
to provide cash flow savings over the next
four years of $1,000; $3,000; $6,000; and
$7,000.
 The Problem (cont.)
• The employee in charge of performing
financial analysis of the proposed investment
has decided to use the IRR as her primary
criterion for making a recommendation to the
managing partner of the firm. If the discount
rate the firm uses to value the cash flows from
office equipment purchases is 15%, is this a
good investment for the firm?
 Step 1: Picture the Problem

0 1 2 3 4
Years
Cash flows -$10,010 +$1,000 +$3,000 +$6,000 +$7,000

IRR =?
 Step 2: Decide on a Solution Strategy

• Here we have to calculate the project’s IRR.

IRR is equal to the discount rate that makes
the present value of the future cash flows (in
years 1-4) equal to the initial cash outflow of
$10,010.

• We can compute the IRR using trial & error,

financial calculator or an excel spreadsheet.
 Step 3: Solve
• Using Mathematical Formula

– This will require finding the rate at which NPV is

equal to zero.
– We compute the NPV at different rates to
determine the range of IRR.
 Step 3: Solve (cont.)
• This table suggests that IRR is between 15 and
20%.

Discount Rate Computed NPV

0% $6,990
5% $4,605
10% $2,667
15% $1,075
20% -$245
 Step 3: Solve (cont.)
• Using an Excel Spread sheet
Rows Column A Column B in
in in Excel Excel
Excel Enter:
1 Year Annual Cash IRR(b2:b6)
flow
2 0 -$10,010
3 1 $1,000
4 2 $3,000
5 3 $6,000
6 4 $7,000
7
8 IRR 19%
 Step 4: Analyze
• The new copying center requires an initial
investment of $10,010 and provides future
cash flows that offer a return of 19%. Since the
firm has decided 15% as the minimum
acceptable return, this is a good investment
for the firm.
 Payback Period
• The Payback period for an investment
opportunity is the number of years needed to
recover the initial cash outlay required to
make the investment.

• Decision Criteria: Accept the project if the

payback period is less than a pre-specified
number of years.
 Limitations of Payback Period
1. It ignores the time value of money
2. The payback period ignores cash flows that
are generated by the project beyond the end
of the payback period.
3. There is no clear-cut way to define the cutoff
criterion for the payback period that is tied to
the value creation potential of the
investment.
 Discounted Payback Period
• Discounted payback period is similar to
payback period except it uses discounted cash
flows to calculate the discounted period. The
discount rate is the same as the one used for
calculating the NPV.
• Decision Criteria: Accept the project if its
discounted payback period is less than the
pre-specified number of years.
Attractiveness of Payback Methods
1. Both payback and discounted payback are
more intuitive and relatively easier to
understand compared to NPV or IRR.

2. Payback period can be seen as a crude

indicator of risk as payback favors initial year
cash flows, which, in general, are less risky
than more distant cash flows.
Attractiveness of Payback Methods (cont.)

3. Discounted payback is used as a

supplemental analytical tool in cases where
obsolescence is a risk and the emphasis is on
getting the money back before the market
disappears or the product becomes obsolete.
4. Payback method is useful when capital is
being rationed and managers would like to
know how long a project will tie up capital.