9. Basics of Capital Expenditure Decisions

Financial Management I

9. Basics of Capital Expenditure Decisions

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Course Content - Syllabus

*Book preference

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, 5

6 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 Expenditure Decisions 18* 11 8

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

11 Risk Analysis and Optimal Capital Expenditure Decision - 13* 12

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Books

1. Financial Management, ICMR Book, Chapter 18

2. Financial Management, Prasanna Chandra, 7th Edition,

Chapter 11

3. Financial Management, I. M. Pandey, 9th Edition, Chapter

8

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Syllabus – Basics 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 Non – Discounted

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 stepsIdentification 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 FactorsRegulatory 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 StudyImplementation• Project Delays

Performance ReviewAspects of Project Appraisal• Market Appraisal: Size of market, project’s 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 and Benefits 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 firm’s 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 such

impact must be quantified and considered for ascertaining

the net cash flows.

• Sunk costs must be ignored. For example, the cost of

existing 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

AnnualCapitalCharge

InternalRate ofReturn(IRR)

BenefitCostRatio(BCR)

NetPresentValue(NPV)

AccountingRate ofReturn(ARR)

PaybackPeriod

Evaluation Criteria

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3.1 Pay-Back Period

Payback period measures the time required to recover the

initial 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 and

Rs. 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.

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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.

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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

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3.1 Pay-Back Period

From PVIFA table, we find thatPVIFA(12,3) = 2.402

PVIFA(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 of money, 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.

years 3.15 2.402 - 3.037

2.402 - 2.5 x 3)(43 PeriodPayback

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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 of for

the industry sector as a whole.

To illustrate the calculation of ARR, consider the project

with the following data.

investment theof ValueBook Average

TaxAfter Profit Average ARR

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(Amount in Rs.)

Average annual income= (30,000+20,000+10,000)/3 = 20,000

Average net book value of investment = (90,000+0)/2=45,000

Accounting rate of return = 20,000 / 45,000 x 100 = 44 %

The firm will accept the project if its target ARR is lower

than 44%.

Year 0 1 2 3

Investment (90,000)

Sales Revenue 1,20,000 1,00,000 80,000

Operating Expenses(excluding depreciation)

60,000 50,000 40,000

Depreciation 30,000 30,000 30,000

Annual Income 30,000 20,000 10,000

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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.

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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

CF NPV

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Example: Consider a project with cash flows as below. Cost of funds to the firm is 12%. Calculate the NPV.

Solution: Net cash flows of the project and their present values 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

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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A project will be accepted if its NPV is positive and rejected if its NPV is negative. NPV is a conceptually sound 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 the shareholders, 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 interpret compared to absolute value like NPV.

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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 flows I = initial investment

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

I

PV BCR

I

NPV NBCR

1I

PV

I

I-PV

1BCR

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BCR and NBCR for the project described in earlier example

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 is

considered 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 compared with 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. 20 lakh

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 accept project 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 by which 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.

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3.5 Internal Rate of Return (IRR)

Internal rate of return (IRR) is that rate of interest at which

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

CF I

0Ik)(1

CF0

n

1tt

t

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While under NPV method the rate of discounting is known

(firm’s 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 the NPV 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 xPVIF(k,4)

With k=18%,

5 xPVIF(0.18,1)+ 4 xPVIF(0.18,2)+ 3 xPVIF(0.18,3)+ 2xPVIF(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 - 10.139 x )17(1817k

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To use IRR as an appraisal criterion, the decision rule based

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 investment appraisal.

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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IRR method suffers from following limitations

IRR is uniquely defined only for a project whose cash flow

pattern is characterized by cash outflow(s) followed by

cash inflows (such projects are called simple investments).

If the cash flow stream has one or more cash outflows

interspersed (at intervals) with cash inflows, there can be

multiple IIRs.

In spite of these defects, IRR is still the best criterion today

to appraise a project financially.

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9. Basics of Capital Expenditure Decisions