capitalexpredecns

8/8/2019 capitalexpredecns

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CAPITAL EXPENDITURE DECISIONS


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CHARACTERISTICS OF CAPITAL BUDGETING

DECISIONS

PROCEDURE INVOLVED IN CAPITAL BUDEGETING

DECISIONS TYPES OF PROJECT APPRAISAL

DETERMINATION OF COSTS AND BENEFITS

ASSOCIATED WITH A PROJECT


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NATURE OF CAPITAL BUDGETING DECSIONS

They influence the firms growth in the long run.

They have an impact on the risk of the firm.

They involve outflow of large amount of funds

They are irreversible in nature

They are complex in nature.


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STEPS INVOLVED IN CAPITAL BUDGETING

DECISIONS

Identification of potential investment opportunities Preliminary screening

Feasibility study

Project implementation

Performance review


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DETERMINING THE COSTS AND BENEFITS ASSOCIATED

WITH THE PROJECT

Costs and benefits should be measured in terms of cash flows,Cash flows = PAT + non-cash charges.

Cash flows must be measured in post-tax terms.

Interest on long-term loans must not be included in net cash flows.

Cash flows should be measured on incremental basis. The impact of the project on existing products should be

accounted for.

Sunk costs must be ignored.

Opportunity costs associated with resources used by the projectshould be considered.


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EVALUATION TECHNIQUES

APPRAISAL CRITERIA IGNORING TIME VALUE OF

MONEY

Pay back Period

Accounting Rate of Return

CRITERIA USING TIME VALUE OF MONEY CONCEPT

Net Present Value

Benefit-Cost Ratio

Internal Rate of Return

Annual Capital Charge


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PAYBACK PERIOD

Pay back Period: Length of time required to recover the initialoutlay of the project.

It is computed as:

Acceptance rule:If Payback period> Cut-off rate: Accept

Limitations:

- Does not consider time value of money

- Gives more importance to cash flows in earlier years

outlaycashAnnual

investmentInitial


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ACCOUNTING RATE OF RETURN

Accounting Rate of Return (ARR) measures the rate of return

on the project using accounting information.

It is computed as:

Acceptance Rule:

Accept the project if ARR> Required rate of return

Limitations:

-Ignores time value of money

-Uses accounting profits and not cash flows in evaluating the

project

investmentofvalueAverage

after taxrofitAverage


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Year PAT for Project A (in Rs.)

1

2

3

4

10,800

9,830

4,230

3,320

Example: A Ltd. is planning to invest in project B. The initial

investment required for project B is Rs. 55,000. The profit after

tax associated with the project, for a period of four years is given

below:

Should the firm accept this project, if the minimum accounting

rate of return required by the company is 22.34%?


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Solution:

Accounting Rate of Return =

Average Profit After Tax = (10,800 + 9,830 + 4,230 + 3,320)/ 4

= Rs. 7045.

Average value of investment = = Rs. 27,500. Accounting Rate of Return = = 0.2562 or 25.62%.

The company can accept this project, as its ARR is greater thanthe minimum or standard ARR.

investmentofvalueAverage

after taxProfitAverage


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APPRAISAL CRITERIA USING THE TIME VALUE OF

MONEY CONCEPT

- NET PRESENT VALUE

- INTERNAL RATE OF RETURN- PROFITABILITY INDEX

- NET BENEFIT COST RATIO

- ANNUAL CAPITAL CHARGE


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NET PRESENT VALUE

Net Present Value (NPV): It is the difference between present

value of cash inflows and present value of outflows.

NPV = PV of cash inflows PV of cash outflows

Acceptance Rule:

Accept the project if NPV>0

Limitations

-Gives inconsistent results while comparing projects with

unequal lives.

- Difficult to determine the precise discount rate.


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Example: X Ltd. is planning to buy machinery for manufacturing a

coolant needed for refrigerators. The cost of the machine is Rs.

50,400. Following are the cash flows associated with the project

over its life period of 5 years.

Year

Cash Flow After Tax

1

2

3

45

Rs. 10,000

Rs. 14,000

Rs. 14,000

Rs. 12,500Rs. 9,800

Based on the NPV criterion, determine whether the new

machine should be bought or not?


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Solution:

Net Present Value = Present value of inflows Present value

of outflows Present value of inflows =

= 8,928.57 + 11,160.71 + 9,964.92 + 7,943.98 + 5,560.78 = Rs.43,558.96.

Hence, NPV = 43,558.96 50,400 = - Rs 6,841.04

The company should not go in for the machinery as the NPV is

negative, in other words the benefits associated with themachinery are less than the costs associated with it.

5)12.01(

800,9

4)12.01(

500,12

3)12.01(

000,14

2)12.01(

000,14

)12.01(

000,10


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BENEFIT-COST RATIO

Benefit-Cost Ratio (BCR) or Profitability Index (PI): It isthe ratio of present value of cash inflows at the required rate

of return and the initial cash outflow of the investment.

Acceptance Rule:

Accept the project if BCR> 1

Limitations:

-Does not give valid results when cash outlay is spread overa number of years.

- Is not useful when multiple projects are acceptable but

budget constraint exists.

investmentInitial

inflowscashoflueresent vaI !


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Solution:

PI =

= 0.8643

Since the profitability index is less than one, we should not buy

the machinery.

investmentInitial

inflowscashofluePresent va


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INTERNAL RATE OF RETURN

Internal Rate of Return (IRR): Rate of return that equates thepresent value of cash inflows to cash outflows.

IRR is the rate at which NPV is zero

Acceptance Rule:

Accept the project if IRR> required rate of return Limitations:

It gives multiple values while dealing with projects having one

or more cash outflows interspersed with cash inflows.


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Example:

Swastik Industries Ltd. wants to expand its business by

investing either in project A or in project B. Both the

projects involve an outlay of Rs. 10,000 and have a life-span

of three years. The cash flows after tax associated with

projects A and B are as follows:

Year Project A

(Amount in Rs.)

Project B

1

2

3

2000

4000

6000

4000

4000

4000

Based on the IRR criterion, determine which project should the

company invest in?


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Solution:

ProjectA

Let r represent the IRR of project A:

10,000 =32 )1(

6000)1(

4000)1(

2000rrr

i.e. 10,000 = 2000 x PVIF(r%, 1 year) + 4000 x PVIF(r%, 2 years) + 6,000

x PVIF(r%, 3 years)

The value of the right hand side of the equation at 9% is = Rs.

9,834.

The value of the right hand side of the equation at 8% is = Rs.

10,044.

Hence, r will lie between 8% and 9%. Interpolating these twovalues we get,

s = 8% + (9%-8%))983410044(

)1000010044(

= 8.21%


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Project B

Let s represent the IRR of project A:

10,000 =32 )1(

4000

)1(

4000

)1(

4000

sss

i.e. 10,000 = 4000 x PVIFA(s%, 1 year)PVIFA(s%, 1 year) = = 2.50

4000

10000

The PVIFA at 9% is 2.531 and PVIFA at 10% is 2.487.Hence s will lie between these two values.

Interpolating the two values we get,

s = 9% + (10%-9%)

= 9.71%

Hence, the company should invest in project B as the IRR for

project B is greater than the IRR for project A.

)487.2531.2(

)50.2531.2(


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ANNUAL CAPITAL CHARGE

Used for evaluating projects providing similar services but

having different cost patterns.

It is computed as:

where, n is the lifespan of the project and

k is the cost of capital of the firm

Acceptance Rule: Project having the lowest annual capital

charge should be accepted

years)n(k ,

P I

projectwith theassociatedcostsoluePresent va


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Example: RK Ltd. has to make a choice between two projects

X and Y having life spans of 5 years and 4 years respectively.

Both the projects provide similar services. The initial investment

and the subsequent costs associated with the two projects aregiven below:

Year

X Y

0

1

2

3

45

4,00,000

10,000

8,000

12,000

4,0003,000

3,85,000

15,000

12,000

16,000

14,000

Which project should the company select if the cost of capital is 9%?


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Solution:

Present value of costs associated with project X =

= 4,00,000 + 10,000 x PVIF(9%, 1 year) + 8,000 x PVIF(9%, 2

years) + 12,000 x PVIF(9%, 3 years) + 4,000 x PVIF(9%, 4 years)

+ 3,000 x PVIF(9%, 5 years)

= 4,00,000 + 10,000 x 0.917 + 8,000 x 0.842 + 12,000 x 0.772 +4,000 x 0.708 + 3,000 x 0.650 = Rs. 4,29,952.

Annual Capital Charge for project X = =

= Rs. 1,10,527.51. (9%,5)PVIFA

4,29,952

89.3

952,29,4


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Present value of costs associated with project Y =

= 3,85,000 + 15,000 x PVIF(9%, 1 year) + 12,000 x PVIF(9%, 2years) + 16,000 x PVIF(9%, 3 years) + 14,000 x PVIF(9%, 4years)

= 3,85,000 + 15,000 x 0.917 + 12,000 x 0.842 + 16,000 x 0.772 +14,000 x 0.708

= Rs. 4,31,123.

Annual Capital Charge for project Y =

= = Rs. 1,33,062.65.

Since the annual capital charge associated with project X is lessthan that for project Y, project X should be selected.

(9%,4)PVIFA4,31,123

24.3

123,31,4

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