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**Capital Expenditure Decisions
**

Presentation By : Sandip Gaudana

Structure

n n n n

**What is ‘Capital Expenditure’ Importance of Cap Ex Decisions Process Appraisal Methods
**

Non Discounting n Discounting

n

**What is Capital Expenditure ?
**

n It is a Decision to invest

Current Funds into Long Term Assets In Anticipation of Expected flow of benefits Over a series of years.

**Types of Cap Ex Decisions
**

n

Expansion of existing business Expansion of new business Replacement and modernisation

n

n

Importance

n n n n n

Growth Risk Funding Irreversibility Complexity

Process

Project Generation

Project Selection

Project Evaluation

Project Execution

Methods of Appraisal

Methods Non Discounted Pay Back Period Accounting Rate of Return Discounted Net Present Value

Internal Rate of Return

Profitability Index

Non Discounted Methods

n Pay Back Period n Accounting Rate of Return

**Pay Back Period
**

n n n n

Payback is the number of years required to recover the original cash outlay invested in a project.

**Example : Equal Cash Flow
**

n Assume that a project requires an outlay of Rs

40,000 and yields annual cash inflow of Rs 10,000 for 7 years. The payback period for the project is:

n Payback = 40,000 = 4 Years

10,000

**Example : Unequal Cash Flow
**

n A project requires a cash outlay of Rs

20,000, and generates cash inflows of Rs 8,000; Rs 7,000; Rs 4,000; and Rs 3,000 during the next 4 years. What is the project’s payback? n 3 Years + 12 * (1,000/3,000) Months n 3 Years, 4 Months

Acceptance & Ranking

n The project would be accepted if its payback

period is less than the maximum or standard payback period set by management. n As a ranking method, it gives highest ranking to the project, which has the shortest payback period.

Some Aspects

n Certain virtues:

n n n

Simplicity Cost effective Short-term effects Cash flows after payback ignored Cash flow patterns Administrative difficulties

n Serious limitations:

n n n

**Accounting Rate of Return
**

n The accounting rate of return is the ratio of the

average after-tax profit divided by the average investment. The average investment would be equal to half of the original investment if it were depreciated constantly.

Example

(Project Cost Rs. 40,000)

ARR = 3,200 * 100 20,000

ARR = 16 %

Acceptance Rule

n This method will accept all those projects whose

ARR is higher than the minimum rate established. if it has highest ARR.

n This method would rank a project as number one

Discounted Methods

n Net Present Value n Internal Rate of Return n Profitability Index

**Net Present Value
**

n Net present value should be found out by subtracting

**present value of cash outflows from present value of cash inflows. n Steps
**

Decide Appropriate rate for discounting n Calculate Present Value of Cash Inflow n NPV = PV of Cash inflows – PV of cash Outflow

n

Example

n Project X costs Rs 2,500 now and is expected to

generate year-end cash inflows of Rs 900, Rs 800, Rs 700, Rs 600 and Rs 500 in years 1 through 5. The opportunity cost of the capital may be assumed to be 10 per cent.

Example

Acceptance Rule

n Accept the project when NPV is positive (NPV > 0) n Reject the projectwhen NPV is negative (NPV < 0) n May accept the project when NPV is zero (NPV = 0) n The NPV method can be used to select between

mutually exclusive projects; the one with the higher NPV should be selected.

Some Aspect

n NPV is most acceptable investment rule for

**the following reasons:
**

n n

Time value Measure of true profitability

n Limitations:

n n

Involved cash flow estimation Discount rate difficult to determine

**Internal Rate of Return
**

n The internal rate of return (IRR) is the rate

that equates the investment outlay with the present value of cash inflow received after one period. n Internal Rate of Return is the discount rate which makes NPV = 0.

**Calculation of IRR : Equal Cashflow
**

n

n

**An investment cost Rs 6,000 and provide annual cash inflow of Rs 2,000 for 5 years.
**

Step : 1 Calculation of Factor

**Factor = Original Investment (6,000) = 3 Avg. Cash flow per year (2,000)
**

n

Referring to Annuity table for 5 years @ 18% ( Rs. 3.127) & @ 20 % ( Rs. 2.99)

Example

(Continued)

IRR = A + [(C- O)/(C-D)] * (B-A) 18 + [ (6,254 – 6,000) / (6254-5980)] * (20-18) 18 + ( 254 / 274) * 2 18 + 1.854 IRR = 19.854 %

Acceptance Rule

n Accept the project when r > k. n Reject the project when r < k. n May accept the project when r = k.

Some Aspects

n IRR method has following merits:

n n n

Time value Profitability measure Acceptance rule Tedious & Difficult to understand Mutually exclusive projects

**n IRR method may suffer from:
**

n n

Profitability Index

n Profitability index is the ratio of the present

value of cash inflows, at the required rate of return, to the initial cash outflow of the investment.

Example

An investment cost Rs 6,000 and provide annual cash inflow of Rs 2,000 for 5 years, consider discounting rate of 18 %

Profitabilty Index = PV of Cash Inflow PV of investment = 6,254 / 6,000 Profitability Index = 1.05

Acceptance Rule

n The following are the PI acceptance rules: n Accept the project when PI is greater than one. PI > 1 n Reject the project when PI is less than one. PI < 1 n May accept the project when PI is equal to one. PI = 1 n The project with positive NPV will have PI

greater than one. PI less than means that the project’s NPV is negative.

Some Aspects

n Recognises the time value of money. n A project with PI greater than one will have

positive NPV and if accepted, it will increase shareholders’ wealth. n Like NPV method, PI criterion also requires calculation of cash flows and estimate of the discount rate. In practice, estimation of cash flows and discount rate pose problems.

Which is more suitable ?

Observations…by authors

n Most commonly used method for evaluating

investment of small size is Pay Back Period n For some of the projects, ARR is used as principal method and Pay Back is supplementary. n Discounted Techniques are gaining importance in Large investments having substantial outlay.

Findings of a Survey

n Survey by U Rao Cherukeri revealed the

following n DCF methods have gained importance over a period of time ( Particularly the IRR) n ARR & PBP are widely used as supplementary evaluation methods. n WACC is commonly used as discount rate. Most often used in india is 15 %

Ranking in US

1. 2. 3. 4. 5. Internal Rate of Return (IRR) Net Present Value (NPV) Accounting Rate of Return (ARR) Pay Back Period (PBP) Profitability Index (PI)

?

Thank You !!!

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