Capital Expenditure Decisions Capital investments = expenditures that will impact many years to come Construction of new facilities Large outlays for vehicles and machinery New product research and development Upfront cost is big and the payback period will span years to come Also called as “investment appraisal” or “capital budgeting” Investment decisions usually involve a number of nonfinancial components as well (architectural, marketing, engineering)

Capital Expenditure Decisions Managers effectively evaluate and rank alternatives The process is matched by reasonable assessment of resource limitations and willingness to assume risk Managers must understand the goals of business owners What is to be optimized? Short-run or long-run performance goals? How much risk is to be undertaken in pursuit of an opportunity? There are analytical tools available to bring logical and rationale decisionmaking process to bear on capital expenditure decisions

The Classification of Investment Projects By the project size Small projects Medium sized projects Large projects By the type of the benefit to the company An increase in cash flow A decrease in risk An indirect benefit (showers for workers, etc)

The Classification of Investment Projects By the degree of dependence Mutually exclusive projects (can execute project A or B, but not both) Complementary projects: taking project A increases the cash flow of project B Substitute projects: taking project A decreases the cash flow of project B By the type of cash flow Conventional cash flow: only one change in the cash flow sign e.g. -/++++ or +/----, etc Non-conventional cash flows: more than one change in the cash flow sign, e.g. +/-/+++ or -/+/-/++++, etc.

The Profitability of the Investment Depends on The investment expenditure and the residual value The annual cash inflows of investment The annual cash outflows of investment The duration of investment (years) The discount rate/the required minimum rate of return on investment

Different Methods to Appraise Investments Profitability Net present value (NPV) Internal rate of return (IRR) Payback period (PP) Accounting rate of return (ARR) More developed methods Simply but much used

Net Present Value (NPV) The NPV method is a theoretically right method to evaluate the investments or projects NPV method offsets the present value of an investment’s cash inflows against the present value of the cash outflows NPV of the net cash flow is then compared to the original investment expenditure If NPV is positive (+): accept the project If NPV is negative(-): reject the project

Net Present Value (NPV) where: NCF = the net cash receipt at the end of the year t IN = the residual value of the investment r = the discount rate/the required minimum rate of return on investment N = the project’s/investment’s duration in years Io= the initial investment expenditure

Net Present Value (NPV) Present value amounts are computed using a firm’s assumed cost of capital The theoretical cost of capital incurred by a firm May be determined by reference to interest rates on debt or a blending of debt/ equity Management may adopt a minimum required threshold rate of return that must be exceeded before an investment will be undertaken

Net Present Value (NPV) Discount rate = the required minimum rate of return on investment The rate can be defined as weighted average cost of capital WACC = (E/V) x RE + (D/V) x RD x (1-Tc) E = Equity D = Debt V = Equity + Debt RE = Return on Equity RD = Return on Debt Tc = Tax rate

Net Present Value (NPV) Example 1: A planned investment outlay is 2 400 000 € The investment is expected to increase cash flows 750 000 € / year for 5 years The residual value is evaluated to be 0 Is the investment profitable if the discount rate is 12 % p.a.?

Net Present Value (NPV) Year Cash flows Discount factor Present value -2 400 000 1 750 000 1/(1+0.12) 2 1/(1+0.12)2 3 1/(1+0.12)3 4 1/(1+0.12)4 5 1/(1+0.12)5

Net Present Value (NPV) Example 1 NPV=(669 643 + 597 895 + 533 835 + 476 639 + 425 570) - 2 400 000 = 2 703 582 - 2 400 000 = 303 582 The investment is profitable with these presumptions

Net Present Value (NPV) Example 2: The company wants to evaluate the profitability of the previous investment if net cash flow will decrease to 700 000 € / year and the demand for discount rate will be 15 %.

Net Present Value (NPV) Year Cash flows Discount factor Present value -2 400 000 1 700 000 1/(1+0.15) 2 1/(1+0.15)2 3 1/(1+0.15)3 4 1/(1+0.15)4 5 1/(1+0.15)5

Net Present Value (NPV) Example 2: NPV =(608 696 + 529 301 + 460 261+ 400 227+ 348 024) – 2 400 000 = 2 346 509 - 2 400 000 = - 53 491 Investment is not profitable anymore

Internal Rate of Return (IRR) IRR is also called the time-adjusted rate of return and the mathematical basis of IRR is not much different than NPV The IRR is defined as any discount rate that results in a net present value of zero, and it is usually interpreted as the expected return generated by the investment In general, if the IRR is greater than the project's cost of capital, the project will add value for the company IRR is used in ranking investment opportunities Accept the project with the highest internal rate of return as long as the rate is at least equal to the firm’s cost of capital

Internal Rate of Return (IRR) Where irr = internal rate of return

The Payback Period (PP) Payback is calculated by dividing the initial investment by the annual cash flow The payback period is the point at which the cumulative net cash inflows begin to exceed the cumulative net cash outflows When deciding between two or more competing projects, the usual decision is to accept the one with the shortest payback

The Payback Period (PP) Years 1 2 3 4 5 Project’s cash flows 1 000 000 250 000 Example 1: For a project with equal annual cash flows PP = Investment expenditure / Annual cash flows = 1 000 000 / 250 000 = 4 years

The Payback Period (PP) Years 1 2 3 4 5 Project’s cash flows 1 000 000 100 000 250 000 300 000 400 000 Example 2: Payback period lies between year 3 and year 4. The sum of money to be recovered by the end of the 4th year = 1 000 000 – (100 000+250 000+300 000) = 350 000 PP = 3 + ( 350 000 / 400 000) = 3.875 years

Disadvantages and Advantages of the payback method: It ignores the timing of cash flows within the payback period, the cash flows after the end of payback period and therefore the total project return It ignores the time value of money It is unable to distinguish between projects with the same payback period It may lead to excessive investment in short-term projects Payback can be important: long payback means, that capital is tied up longer, so the investment risk is higher It involves a quick, simple calculation and an easily understood concept