CAPITAL EXPENDITURE DECISIONS

1
 CAPITAL EXPENDITURE DECISIONS

• CHARACTERISTICS OF CAPITAL BUDGETING

DECISIONS
• PROCEDURE INVOLVED IN CAPITAL BUDEGETING
DECISIONS
• TYPES OF PROJECT APPRAISAL
• DETERMINATION OF COSTS AND BENEFITS
ASSOCIATED WITH A PROJECT

2
 NATURE OF CAPITAL BUDGETING DECSIONS

• They influence the firm’s 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.

3
 STEPS INVOLVED IN CAPITAL BUDGETING
DECISIONS
• Identification of potential investment opportunities
• Preliminary screening
• Feasibility study
• Project implementation
• Performance review

4
 TYPES OF PROJECT APPRAISAL

• MARKET APPRAISAL
• TECHNICAL APPRAISAL
• FINANCIAL APPRAISAL
• ECONOMIC APPRAISAL

5
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 project
should be considered.

6
 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

7
 PAYBACK PERIOD
• Pay back Period: Length of time required to recover the initial
outlay of the project.
• It is computed as: Initial investment
Annual cash outlay

• 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

8
 ACCOUNTING RATE OF RETURN
• Accounting Rate of Return (ARR) measures the rate of return
on the project using accounting information.
• It is computed as: Average Profit after tax
Average value of investment

• 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
9
 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:
Year PAT for Project A (in Rs.)
1 10,800
2 9,830
3 4,230
4 3,320

Should the firm accept this project, if the minimum accounting

rate of return required by the company is 22.34%?

10
Solution: Average Profit after tax
• Accounting Rate of Return =
Average value of investment

• 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 than
the minimum or standard ARR.

11
 CAPITAL EXPENDITURE DECISIONS

• 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

12
 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.

13
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.

Cash Flow After Tax

Year
1 Rs. 10,000
2 Rs. 14,000
3 Rs. 14,000
4 Rs. 12,500
5 Rs. 9,800
Based on the NPV criterion, determine whether the new
machine should be bought or not?
14
Solution:
• Net Present Value = Present value of inflows – Present value
of outflows
• Present value of inflows =
10 , 000 14 , 000 14 , 000 12 , 500 9 ,800
   
(1 0.12 ) (1 0.12 ) 2 (1 0.12 )3 (1 0.12 ) 4 (1 0.12 )5

= 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 the
machinery are less than the costs associated with it.

15
 BENEFIT-COST RATIO
• Benefit-Cost Ratio (BCR) or Profitability Index (PI): It is
the ratio of present value of cash inflows at the required rate
of return and the initial cash outflow of the investment.
Present value of cash inflows
PI 
Initial investment
• Acceptance Rule:
Accept the project if BCR> 1
• Limitations:
-Does not give valid results when cash outlay is spread over
a number of years.
- Is not useful when multiple projects are acceptable but
budget constraint exists.
16
Solution:
PI = Present value of cash inflows
Initial investment

= 0.8643

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

17
 INTERNAL RATE OF RETURN
• Internal Rate of Return (IRR): Rate of return that equates the
present 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.

18
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 Project B
(Amount in Rs.)
1 2000 4000
2 4000 4000
3 6000 4000

Based on the IRR criterion, determine which project should the

company invest in?

19
 Solution:
Project A
Let r represent the IRR of project A:
10,000 = 2000  4000  6000
(1  r ) (1  r ) 2 (1  r ) 3
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 two
values we get, (10044  10000) = 8.21%
s = 8% + (9%-8%) (10044  9834)

20
Project B
Let s represent the IRR of project A:
10,000 = 4000  40002  40003
(1  s ) (1  s ) (1  s )

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

10000
PVIFA(s%, 1 year) = = 2.50
4000
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,
( 2.531  2.50)
s = 9% + (10%-9%)
( 2.531  2.487)
= 9.71%
Hence, the company should invest in project B as the IRR for
project B is greater than the IRR for project A.
21
 ANNUAL CAPITAL CHARGE
• Used for evaluating projects providing similar services but
having different cost patterns.
• It is computed as:
Present value of costs associated with the project
PVIFA (k%, n years)

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

22
 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 are given below:
X Y
Year
0 4,00,000 3,85,000
1 10,000 15,000
2 8,000 12,000
3 12,000 16,000
4 4,000 14,000
5 3,000

Which project should the company select if the cost of capital is 9%?
23
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.

4,29,952 4,29,952
Annual Capital Charge for project X = = 3.89
PVIFA (9%,5)
= Rs. 1,10,527.51.

24
Present value of costs associated with project Y =
= 3,85,000 + 15,000 x PVIF(9%, 1 year) + 12,000 x PVIF(9%, 2
years) + 16,000 x PVIF(9%, 3 years) + 14,000 x PVIF(9%, 4
years)
= 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. 4,31,123
Annual Capital Charge for project Y = PVIFA
(9%,4)

4,31,123
= 3.24 = Rs. 1,33,062.65.

Since the annual capital charge associated with project X is less

than that for project Y, project X should be selected.

25