70102117-9-basics-of-capital-expenditure-decisions.pptx

8/10/2019 70102117-9-Basics-of-Capital-Expenditure-Decisions.pptx

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Financial Management I

9. Basics of Capital Expenditure Decisions

Dr. Suresh

[email protected]

Phone: 40434399, 25783850


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Course Content - Syllabus

*Book reference

Sr Title ICMR Ch. PC Ch. IMP Ch.

1 Introduction to Financial Management 1* 1 1

2 Overview of Financial Markets 2* 2 -

3 Sources of Long-Term Finance

10* 17 20, 21

4 Raising Long-term Finance

- 18* 20, 21, 23

5 Introduction to Risk and Return

4* 8, 9 4, 56 Time Value of Money

3* 6 2

7 Valuation of Securities 5* 7 3

8 Cost of Capital

11* 14 9

9 Basics of Capital ExpenditureDecisions

18* 11 8

10 Analysis of Project Cash Flows - 12* 10, 11

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Basics of Capital Expenditure Decisions

Reference Books

1. Financial Management, ICMR Book, Chapter 18

2. Financial Management, Prasanna Chandra, 7th

Edition,

Chapter 11

3. Financial Management, I. M. Pandey, 9thEdition,

Chapter 8


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SyllabusBasics of Capital Expenditure Decisions

1. The Process of Capital Budgeting

2. Basic Principles in Estimating Cost and Benefits of

Investments

3. Appraisal Criteria: Discounted and NonDiscounted

Methods (Pay-Back Period, Average Rate of Return,

Net Present Value, Benefit Cost Ratio, Internal Rate of

Return)


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Investment decisions has following steps

Identification of Potential Investment Opportunities

Potential sources of Project Ideas

Market Characteristics of Different Industries

Product Profiles of Various Industries Imports and Exports

Emerging Technologies

Social and Economic Trends

Consumption Patterns in Foreign Countries Revival of Sick Units

Backward and Forward Integration

Chance Factors

Regulatory Framework and Policies


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Preliminary Screening

Compatibility with the Promoter

Compatibility with the Government Priorities

Availability of Inputs

Size of the Potential Market

Reasonableness of Cost

Feasibility Study

Implementation

Project Delays

Performance ReviewAspects of Project Appraisal

Market Appraisal: Size of market, projects market share

Technical Appraisal: Technical aspects, implementation, technology

Financial Appraisal: Risk and returns, cost benefits analysis Economic Appraisal: Social cost benefit analysis


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2. Basic Principles in Estimating Cost andBenefits of Investments

Basic principles in estimating cost (outflow) and benefits

(inflow) of investments are as follows

All costs and benefits must be measured in terms of cash

flows. This implies that all non-cash charges (expenses)like depreciation which are considered for the purpose of

determining the profit after tax must be added back to

arrive at the net cash flows for our purpose. Since the net cash flows relevant from the firms point of

view are what that accrue to the firm after paying tax,

cash flows for the purpose of appraisal must be defined

in post-tax terms.


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Usually the net cash flows are defined from the point of

view of the suppliers of long-term funds (i.e. suppliers of

equity capital and long-term loans).

Interest on long-term loans must not be included for

determining the net cash flows.

Cash flows must be measured in incremental terms. In

other words, the increments in the present levels of costs

and benefits that occur on account of the adoption of the

project are alone relevant for the purpose of determining

the net cash flows.


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Some implications of this principle are as follows

If the proposed project has a beneficial or detrimental

impact on say, other product lines of the firm, then suchimpact must be quantified and considered for

ascertaining the net cash flows.

Sunk costs must be ignored. For example, the cost ofexisting land must be ignored because money has already

been sunk in it and no additional or incremental money

is spent on it for the purpose of this project.


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Opportunity costs associated with the utilization of the

resources available with the firm must be considered

even though such utilization does not entail explicit cash

outflows. For example, while the sunk cost of land is

ignored, its opportunity cost i.e. the income it would have

generated if it had been utilized for some other purpose

or project must be considered.

The share of the existing overhead costs which is to be

borne by the end products of the proposed project must

be ignored.


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3. Appraisal Criteria:

Discounted and Non - Discounted Methods

Non-Discounting Criteria Discounting Criteria

Annual

Capital

Charge

Internal

Rate of

Return

(IRR)

Benefit

Cost

Ratio

(BCR)

Net

Present

Value(NPV)

Accounting

Rate of

Return

(ARR)

Payback

Period

Evaluation Criteria


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3.1 Pay-Back Period

Payback period measures the time required to recover theinitial outlay in the project. For example, if a project

with life of 5 years involves an initial outlay of Rs. 20

lakh and is expected to generate a constant annual inflow

of Rs. 8 lakh,

Payback period = 20 / 8 = 2.5 years.

If the same project is expected to generate annual inflows

of say Rs. 4 lakh, Rs. 6 lakh, Rs. 10 lakh, Rs. 12 lakh andRs. 14 lakh, then

Payback period = 3 years, because inflows in first three

years is equal to the initial outlay.


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3.1 Pay-Back Period

To use payback period method for accepting or rejecting

the projects, the firm has to decide an appropriate cut-

off period. Projects with payback period up to the cut-off

period are accepted and beyond the cut-off period are

rejected.

Advantages of cut-off period method

It is simple in concept and application

It helps in rejecting risky projects and accepting those projects

which generate substantial inflows in earlier years.

i


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3.1 Pay-Back Period

Disadvantages of cut-off period method

It does not consider the time value of money

The cut-off period is chosen arbitrarily and applied for

evaluating projects regardless of their life spans. Consequently

the firm may accept too many short-lived projects and too few

long-lived ones.

Payback period method leads to discrimination against projects

which generate substantial cash inflows in later years, the

criterion cannot be considered as a measure of profitability.

3 1 P B k P i d


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3.1 Pay-Back Period

To incorporate the time value of money, discounted

payback period is used. In this method, the firms

discount the cash flows before they compute the payback

period. For example, if a project involves an initial

outlay of Rs. 20 lakh and is expected to generate a net

annual inflow of Rs. 8 lakh for the next 4 years.

Assuming cost of funds to be 12%, the discounted

payback period is calculated as

8 x PVIFA(12,n)= 20

PVIFA(12,n)

= 2.5

3 1 P B k P i d


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3.1 Pay-Back Period

From PVIFA table, we find that

PVIFA(12,3) = 2.402PVIFA(12,4) = 3.037

By linear interpolation

We find that the discounted payback period is longer

than undiscounted payback period.

Discounted payback period considers the time value ofmoney, still it suffers from other disadvantages of

payback period method. Hence in practice, companies do

not give much importance to payback period as an

appraisal criteria.

years3.152.402-3.037

2.402-2.5

x3)(43PeriodPayback

3 2 A ti R t f R t (ARR)


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3.2 Accounting Rate of Return (ARR)

Accounting rate of return (ARR) also called as book rate

of return is defined as

To use it as an appraisal criterion, ARR of a project is

compared with ARR of the firm as a whole or ARR offor the industry sector as a whole.

To illustrate the calculation of ARR, consider the project

with the following data.

investmenttheofValueBookAverage

TaxAfterProfitAverageARR


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Advantages of ARR

Like payback method, ARR is simple in concept and

application. It appeals to the businessmen who find the concept

of ARR familiar and easy to use.

It considers the returns over the entire life of the project and

therefore serves as a measure of profitability(unlike the

payback period which is a measure of capital recovery)



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Disadvantages of ARR

This criterion ignores the time value of money. That is, it gives

no allowance for immediate receipts, which are more valuable

than the distant flows.

ARR depends on accounting income and not on the cash flows.A profitability measure based on accounting income cannot be

used as a reliable investment appraisal criterion.

The firm using ARR as an appraisal criterion must decide on a

yard-stick for judging a project and this decision is often

arbitrary. Often firms use their current book return as the

yard-stick for comparison. In such cases, if the current book

return of a firm tends to be very high or low, then the firm can

end up rejecting good project or accepting bad projects.

3 3 N t P t V l (NPV)


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3.3 Net Present Value (NPV)

Net present value (NPV) is equal to the present value of

future cash flows and any immediate cash outflows. In

the case of a project, NPV will be equal to the present

value of future cash inflows minus initial investment

(cash outflow).

Where k = cost of funds

CFt= cash flows at the end of the period t

I0= initial investment

n = life of the investment

n

1t

0t

tI

k)(1

CFNPV



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Example: Consider a project with cash flows as below.

Cost of funds to the firm is 12%.

Calculate the NPV.

Year 0 1 2 3 4

Initial Investment

(cash outflows)(12,500)

Cash inflows 5,100 5,100 5,100 7,100



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Solution: Net cash flows of the project and their presentvalues are as follows.

Net present value = (-12,500)+(4,554+4,065+3,631+4,516)

= Rs. (-12,500 + 16,766)

= Rs. 4,266

Year 1 2 3 4

Net cash flow (Rs.) 5100 5100 5100 7100

PVIF @ k = 12% 0.893 0.797 0.712 0.636

Present value (Rs.) 4554 4065 3631 4516



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A project will be accepted if its NPV is positive and

rejected if its NPV is negative. NPV is a conceptuallysound criterion of investment appraisal because it takes

into account the time value of money and considers the

entire cash flow stream.

NPV represents the contribution to the wealth of theshareholders, maximizing NPV is congruent with the

objective of investment decision making viz.

maximization of shareholders wealth.

Only problem in applying this criterion appears to be the

difficulty in comprehending the concept. Most non-

financial executives and businessmen find Return on

Capital Employed or Accounting Rate of Return easy

to inter ret com ared to absolute value like NPV.

3 4 Benefit Cost Ratio (BCR)


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3.4 Benefit Cost Ratio (BCR)

Benefit cost ratio (or the profitability index) is defined as

Where BCR = benefit cost ratio

PV = present value of future cash flowsI = initial investment

A variant of the BCR is net benefit cost ratio (NBCR)

which is defied as

I

PVBCR

I

NPVNBCR

1

I

PV

I

I-PV

1BCR



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BCR and NBCR for the project described in earlierexample will be

BCR = 16,766 / 12,500 = 1.34

NBCR = 4,266 / 12,500 = 0.34

Decision rule based on BCR (or alternatively NBCR)

criterion will be as follows

If Decision Rule

BCR > 1 (NBCR > 0) Accept the project

BCR < 1 (NBCR < 0) Reject the project



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BCR measures the present value per rupee of outlay, it isconsidered to be useful criterion for ranking a set of

projects in the order of decreasingly efficient use of

capital.

There are two serious limitations inhibiting the use of this

criterion.

First, it provides no means for aggregating several

smaller projects into a package that can be comparedwith a large project.

Second, when the investment outlay is spread over more

than one period, this criterion cannot be used.

Following example illustrates the first limitation.



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Example: Company is considering 4 projects A, B, C and

D with following characteristics

The funds available for investment are limited to Rs. 20lakh and the cost of funds to the firm is 14%. Rank the 4

projects in terms of the NPV and BCR criteria.

Determine which project(s) will you recommend given

the limited supply of funds.

ProjectInitial investment

(at year 0)

Annual net cash flow

(year 1 to 5)

A (20) 7.5

B (4.5) 1.5

C (7) 2.5

D (8) 3.5



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Solution: The NPVs of the 4 projects are

The BCR of the 4 projects are

Project NPV (Rs. In lakh) Rank

A 7.5 x PVIFA(14,5)20 = (7.5 x 3.433)20 = 5.75 I

B 1.5 x PVIFA(14,5)4.5 = (1.5 x 3.433)4.5 = 0.65 IV

C 2.5 x PVIFA(14,5)7 = (2.5 x 3.433)7 = 1.58 III

D 3.5 x PVIFA(14,5)8 = (3.5 x 3.433)8 = 4.02 II

Project BCR Rank

A 25.75 / 20 = 1.27 II

B 5.15 / 4.5 = 1.14 IV

C 8.58 / 7 = 1.23 III

D 12.02 / 8 = 1.50 I



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Based on the NPV and BCR criterion, all 4 projects are

acceptable because NPVs are positive and BCRs are

greater than one for each project.

But all 4 projects cannot be taken by the firm because of

the limited availability of funds. Company has to acceptproject A or a package consisting of projects B, C and D

but not both. The decision depend on which option

maximizes the shareholders wealth. In this situation,

BCR becomes inapplicable because there is no way bywhich we can aggregate the BCRs of projects B, C and

D. On the other hand NPVs of projects B, C and D can

be aggregated and compared with the NPV of project A

to arrive at a decision.



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NPV(B+C+D) = NPV(B) + NPV(C) + NPV(D)

= 0.65 + 1.58 + 4.02

= 6.25

This is more than NPV(A) which is 5.75.

Therefore the package comprising projects B, C an D

must be accepted.

3 5 Internal Rate of Return (IRR)


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3.5 Internal Rate of Return (IRR)

Internal rate of return (IRR) is that rate of interest atwhich the net present value of a project is equal to zero.

In other words, IRR is the rate which equates the present

value of the cash inflows to the present value of the cash

outflows.

Where k = IRR, is that rate of return where

CFt= cash flows at the end of period t

I0 = initial investment

n = life of the investment

n

1tt

t0

k)(1

CFI

0Ik)(1CF 0

n

1tt

t



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While under NPV method the rate of discounting is known(firms cost of capital), under IRR this rate which makes

NPV zero has to be found out. Following example

illustrates this concept.Example: A project has the following pattern of cash

flows. Calculate the IRR of this project.Year Cash flow (Rs. in lakh)

0 (10)

1 5

2 4

3 3

4 2



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Solution: To determine the IRR, we have to compute theNPV of the project for different rates of interest until we

find that rate of interest at which the sum of present

values of all cash flows is equal to the initial investment.

Number of iterations are involved in this trial and error

method.

10 = 5 x PVIF(k,1)+ 4 x PVIF(k,2)+ 3 x PVIF(k,3)+ 2 x PVIF(k,4)

With k=18%,5 xPVIF(0.18,1)+ 4 xPVIF(0.18,2)+ 3 xPVIF(0.18,3)+ 2 xPVIF(0.18,4)

= 5 x 0.847+ 4 x 0.718+ 3 x 0.609+ 2 x 0.516

= 9.966

Next trial with 17%



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5 xPVIF(0.17,1)+ 4 xPVIF(0.17,2)+ 3 xPVIF(0.17,3)+ 2 xPVIF(0.17,4)= 5 x 0.855+ 4 x 0.731+ 3 x 0.624 + 2 x 0.534

= 10.139

k lies between 17% and 18%By linear interpolation

= 17 + 0.80

= 17.80 %

9.967-10.139

10-10.139x)17(1817k



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To use IRR as an appraisal criterion, the decision rulebased on IRR will be: Accept the project if the IRR is

greater than the cost of funds employed, else reject the

project. IRR is a popular method of investmentappraisal.

Advantages of IRR method

It takes into account the time value of money

It considers the entire cash flow stream over the investment

horizon

Like ARR, it makes sense to businessmen who prefer to think

in terms of rate of return on capital employed.


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70102117-9-basics-of-capital-expenditure-decisions.pptx

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