9. Basics of Capital Expenditure Decisions

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Financial Management I

9. Basics of Capital Expenditure Decisions

suresh.suralkar@gmail.com, Phone: 40434399

Course Content - SyllabusSr Title ICMR Ch. 1* 2* 10* 4* 3* 5* 11* 18* PC Ch. 1 2 17 18* 8, 9 6 7 14 11 12* 13* IMP Ch. 1 20, 21 20, 21, 23 4, 5 2 3 9 8 10, 11 122 / 36

1 Introduction to Financial Management 2 Overview of Financial Markets 3 Sources of Long-Term Finance 4 Raising Long-term Finance 5 Introduction to Risk and Return 6 Time Value of Money 7 Valuation of Securities 8 Cost of Capital 9 Basics of Capital Expenditure Decisions 10 Analysis of Project Cash Flows and Optimal Capital 11 Risk AnalysisDecision Expenditure

*Book preference

Books1. 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 Decisions1. 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)4 / 36

1. The Process of Capital BudgetingInvestment 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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1. The Process of Capital BudgetingPreliminary 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 Review Aspects 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 6 / 36

2. Basic Principles in Estimating Cost and Benefits of InvestmentsBasic 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. 7 / 36

2. Basic Principles in Estimating Cost and Benefits of Investments 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.8 / 36

2. Basic Principles in Estimating Cost and Benefits of InvestmentsSome 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.9 / 36

2. Basic Principles in Estimating Cost and Benefits of Investments 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.10 / 36

3. Appraisal Criteria: Discounted and Non - Discounted MethodsEvaluation CriteriaNon-Discounting CriteriaPayback Period Accounting Rate of Return (ARR) Net Present Value (NPV)

Discounting CriteriaBenefit Cost Ratio (BCR) Internal Rate of Return (IRR) Annual Capital Charge

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3.1 Pay-Back PeriodPayback 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.12 / 36

3.1 Pay-Back PeriodTo 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.13 / 36

3.1 Pay-Back PeriodDisadvantages 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.14 / 36

3.1 Pay-Back PeriodTo 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) = 2.515 / 36

3.1 Pay-Back PeriodFrom PVIFA table, we find that PVIFA(12,3) = 2.402 PVIFA(12,4) = 3.037 By linear interpolation2.5 - 2.402 Payback Period ! 3 (4 3) x ! 3.15 years 3.037 - 2.402

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 16 / 36 criteria.

3.2 Accounting Rate of Return (ARR)Accounting rate of return (ARR) also called as book rate of return is defined asAverage rofit After Tax ARR ! Average Book Value of the investment

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.17 / 36

3.2 Accounting Rate of Return (ARR)(Amount in Rs.)Year Investment Sales Revenue Operating Expenses (excluding depreciation) Depreciation Annual Income 0 (90,000) 1,20,000 60,000 30,000 30,000 1,00,000 50,000 30,000 20,000 80,000 40,000 30,000 10,000 1 2 3

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%. 18 / 36

3.2 Accounting Rate of Return (ARR)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)19 / 36

3.2 Accounting Rate of Return (ARR)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. 20 / 36

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).CFt N V! I0 t t !1 (1 k)n

Where k = cost of funds CFt = cash flows at the end of the period t I0 = initial investment n = life of the investment21