2. Introduction  Decisions regarding acquisition of fixed assets and other long-term projects of the company are critical to the future profitability and success of the company.  Such investment includes purchase of equipment, acquisition of land and buildings, introduction of new products and so on.

3. Introduction  The importance of capital investments also lie in the fact that large sums of money are normally sunk into these investments and once decisions on them are made, they are nearly always irretrievable.  Whereas the returns on these investments go into the future and may be highly uncertain in some cases, the expenditure on them is now.

4. Introduction  The future cash flows have to be properly estimated and this is the most difficult aspect of the planning and evaluation process.  Having estimated the future cash flows of each capital investment available, will evaluate each investment proposal using the appropriate appraisal techniques.  Each investment proposal should be assessed on the basis of its ability to achieve the minimum expected return by the providers of t he funds that will be channeled to that proposal.

5. Capital Expenditures  Refer to substantial outlay of funds the purpose of which is to lower costs and increase net income for several years in the future. It includes expenditures that tie up capital inflexibility for long periods. It covers not only outlays for fixed assets but also expenditures for major research on new products and methods and for advertising that has cumulative effects

6. Classes of Capital Expenditures  Replacement investments  Expansion investments  Product line or new market investments  Investments in safety and/or environmental projects  Strategic investments  Other investments

7. Capital Expenditure Planning and Control  Capital Expenditure planning and control is a process of facilitating decisions covering expenditure on long- term assets.  Capital Expenditures – include all expenditures on tangible and in some cases intangible assets which are expected to produce benefits to the firm over a period of time (not less than one year.)  Capital Expenditure Planning and Control is an integral part of the corporate plan of an organization

8. Capital Expenditure Planning and Control  The Capital Budgeting process includes: a. Identification b. Development c. Evaluation d. Authorization e. Control

9. Identification of investment opportunities  Identification of investment proposals is the most critical aspect of the investment process and should be guided by the overall strategic considerations of a firm.  Once the investment proposal has been identified, each potential idea should be developed into a project and submitted for appraisal to determine its viability and worthiness.

10. Identification of investment opportunities  A sound appraisal technique which should maximize the shareholder’s wealth should be used to measure the economic worth of the projects.  In this respect, there would be a need to consider all cash flows, to determine the true profitability of the project. This will involve the development of cash flow estimates.

11. Developing Cash Flow Estimation  Estimation of cash flow is a difficult task because the future is uncertain. Therefore, the risk associated with cash flow should be handled properly and taken into account in the decision process as the estimation of cash flow requires collection and analysis of all quantitative and qualitative data.

12. Evaluation of the Net Benefits  In selecting a method or methods of investment evaluation, a company should take adequate care to ensure that the criteria selected would lead, to the net increase in the company’s wealth, that is, its benefit exceeds its cost adjusted for time value and risk.  The evaluation criteria should also not discriminate between investment proposals.  Whatever criterion that is applied, it should be capable of ranking projects correctly in terms of profitability.

13. Evaluation of the Net Benefits  In this particular case, the net present value method (NPV) is theoretically recommended, among others by experts as it has a true measure of profitability. It ranks projects correctly and is consistent with the wealth maximization criterion.  However, other methods in use apart from the NPV are the payback period, the internal rate of return (IRR), accounting rate of return (ARR) and profitability index (PI).

14. Evaluation of the Net Benefits  In the implementation of a sophisticated evaluation system, the use of a minimum required rate of return is necessary. This should be based on the riskiness of cash flows of the investment proposal which are considered to be normally influenced by the following factors: a. Price of raw materials and other inputs; b. Price of products (selling price); c. Product demand; d. Government policies; e. Technological changes; f. Project life; and g. Inflation

15. Authorization to Spend  There is no specific standard administration procedure for approving investment proposal as it differs from one company to another.  When large sums of capital expenditure is involved, the authority for the final approval may rest with the Board or the top management which may be the Chief Executive of the company.  The approval authority may be delegated to the junior management for certain types of investment project involving small amounts.

16. Authorization to Spend  Funds are usually appropriated for capital expenditure from the capital budget after the final selection of investment proposals.  Top management are to ensure that funds are spent in accordance with appropriations made in the capital budget.  Funds for the purpose of project implementation should be spent only after approval has been granted by the finance manager or any other authorized person.

17. Control and Monitoring of Capital Projects  A capital project reporting system is required to review and monitor the performance of investment projects during and after completion.  This will mean comparing the actual performance with original estimates. It will require regular reporting either monthly, quarterly or semi-annually.  The evaluation reports may among others include information on expenditure to date, stage of physical completion and approved and revised total cost.

18. Control and Monitoring of Capital Projects  The reappraisal may also include consideration of the comparison between actual and forecast capital cost savings and rate of return. The perceived advantages of reappraisal are: a. Improvement in profitability by positioning the project as per the original plan; b. Ascertaining of errors in investment planning which can be avoided in the future; c. Guidance for future evaluation of projects; and d. Generation of cost consciousness among the project team.

19. Investment Appraisal Techniques  Investment decisions affect the value of the firm and this will increase, if investments are profitable and add to shareholder’s wealth.  It is, therefore important to ensure that investments are evaluated on the basis of criteria which are compatible with the objective of the shareholder’s wealth maximization.  It is necessary to examine the different methods of selecting investment in long-term assets, that is, capital expenditure, to be able to determine the most valid technique of evaluating an investment project.

20. Investment Appraisal Techniques  A number of capital budgeting techniques are used in practice. They are grouped into two major categories: 1. Discounted Cash Flow (DCF) Techniques a. Net Present Value (NPV) b. Internal Rate of Return (IRR) c. Profitability index (PI); and d. Discounted payback period 2. Non- Discounted Cash Flow Techniques

21. Investment Appraisal Techniques  It is important to emphasize that expenditure on and benefits of an investment should be measured in cash. In this respect, it is the cash flow that is important and not the accounting profit.  However, it is assumed that the capital projects opportunity cost of capital (rate of return) is known.  It is also assumed that the expenditure and benefits of the investment are known with certainty.

22. Investment Appraisal Techniques 1. Non- Discounted Cash Flow Techniques a. Payback Period (PB); and b. Accounting Rate of Return (ARR)  In evaluating an investment, three steps are involved: a. Estimation of cash flows; b. Estimation of the required rate of return (cost of capital); c. Application of a decision rule for making the choice

23. Non-Discounted Cash Flow Techniques  Payback period technique  This technique shows the number of years over which the investment would be recovered.  It is the period usually expressed in years, in which the cash outflows will equate the cash inflows from a project.  This technique measures projects on the basis of the period over which the investment pays back itself or the period of recovery of the initial investment.  The full recovery of the projects cash outflow would be measured through the cash inflows.

24. Payback Period Technique  This method pays attention to the shortness of the project, that is, the shorter the period of recovery of initial investment or capital outlay, the more acceptable the project becomes.  Where there is constant or uniform annual net cash flows from a project, the payback period is calculated thus:  Payback Period = Initial Investment (Capital Outlay) Annual Net Cash Flow

25. Payback Period Technique  Decision rule  If the payback period is calculated for a project is less than the maximum or standard payback period set by management, it would be accepted, if not, it would be rejected.  If the firm has to choose among two mutually exclusive projects the project with shorter payback period will be selected.

26. Payback Period Technique  Advantages of Payback Method a. It is simple to calculate and better understood of all the methods of capital budgeting. b. It least exposes the firm to the problem of uncertainty since it focuses on shortness of project to pay back the initial outlay. c. It is a fast screening technique especially for the firms that have liquidity problems.

27. Payback Period Technique  Disadvantages of Payback Method a. It does not take account of the cash inflows earned after the payback period. b. It does not take into account the time value of money c. It does not take into account the risks associated with each project and the attitude of the company to risk.

28. Accounting Rate of Return  The accounting rate of return (ARR) technique is derived from the concept of return on capital employed (ROCE) which is also known as return on investment (ROI).  It uses accounting information provided by the financial statements to measure the profitability of an investment. It is calculated by dividing the average after-tax-profit by the average book value of the investment during its life.

29. Accounting Rate of Return  ARR = Average Income____ x 100% Average Investment  Decision Rule:  The rule is to invest in all projects whose accounting rate of return (ARR) are higher than the company’s pre- determined minimum acceptable rate  Where mutually exclusive projects are concerned, the rule is to accept the project with the highest ARR

30. Accounting Rate of Return  Advantages of Accounting Rate of Return  It is easy to calculate  It is simple to understand and use  It incorporates the entire stream of income in calculating the project’s profitability.

31. Accounting Rate of Return  Disadvantages of Accounting Rate of Return  It uses accounting profits in appraising the projects.  The averaging of income ignores the time value of money.  It uses an arbitrary cut off yardstick  It is an average concept and as such will hide the sizes and timing of the individual cash flows.  It does not take into consideration the risk associated with each project as well as the attitude of the management to risk.  There is no unique definition for ARR. For instance “average profit” may be profits after depreciation, interest and tax. Initial investment could be initial investment plus scrap value or just initial investment.

32. Discounted Cash Flow (DFC) Techniques  Net Present Value (NPV) Method  is one of the discounted cash flow techniques that recognizes the time value of money  It is the net contribution of a project to its owners wealth,  It is the present value of future cash flows minus the present value of the initial capital investment.  All cash flows are discounted to their present values using the required rate of return.

33. Net Present Value (NPV) Method  The formula for calculating NPV are as follows

34. Net Present Value (NPV) Method  Advantages of NPV a. It recognizes the time value of money’ b. It uses all cash flows occurring over the entire life of the project; c. It measures in absolute terms (Peso/Dollar value) the increase in wealth of the shareholders; and d. It facilitates measuring of cash flows in terms of present values. This implies that if the values of separate assets are known, the firms value can simply be found by adding their values. This is called the value-additivity principle.

35. Net Present Value (NPV) Method  Disadvantages of NPV a. It is more difficult to calculate than the payback and the accounting rate of return; and b. It relies heavily on the correct estimation of the cost of capital, that is, where errors occur in the cost of capital used for discounting, the decision would be misleading.

36. Internal Rate of Return (IRR)  The internal rate of return method is another discounted cash flow technique which takes account of the time value of money.  It is also known as yield of a project, marginal efficiency capital, rate of return over cost, time adjusted rate of return and so on.  It is defined as the cost of capital for which the NPV of a project would be zero.

37. Internal Rate of Return (IRR)  It is a break-even point cost of capital. It is also the cost of capital or discount rate that will equate the cash inflows of a project with the cash outflows of that project.  The formula for calculating the IRR is:

38. Internal Rate of Return (IRR)  The formula shows that it is the same as that for calculating NPV.  The only difference is that in NPV method, the required rate of return is assumed to be known while in IRR method the required rate of return has to be determined, hence, the result is equated to zero.

39. Internal Rate of Return (IRR)  An alternative method to the above formula is the trial and-error method. This is also know as interpolation method.  In this method, the discounting factor yielding a positive NPV is improved to move towards negative and a midway is discovered to arrive at zero. The formula:

40. Internal Rate of Return (IRR)  Decision rule:  Accept all projects whose IRR are greater than the company’s cost of capital. i.e. Accept if r > k Reject if R < k May accept or reject if r = K Where r = internal rate of return and k = cost of capital If mutually exclusive projects are being considered the rule is to accept the project that produces the highest IRR.

41. Internal Rate of Return (IRR)  Advantages of IRR a. It recognizes the time value of money b. It considers all cash flows occurring over the entire life of the project c. It gives the same acceptance rule as the NPV method d. It is consistent with the stakeholders wealth maximization objective.

42. Internal Rate of Return (IRR)  Disadvantages of IRR a. It is more difficult to calculate than the other methods. b. It can give misleading and inconsistent results when the NPV of a project does not decline with discount rates. c. In some cases, it fails to indicate a correct choice between mutually exclusive projects. d. Unlike in the case of NPV, the additivity principle does not hold when IRR method is used – IRR projects do not add e. Sometimes, it yields multiple rates.

43. Profitability Index (PI) Technique  The profitability index (PI) method is another cash flow technique.  It is the ratio of the present value of cash inflows, at the required rate of investment. It may be gross or net that is, gross minus one. 1 +

44. Profitability Index (PI) Technique  Decision rule  Accept all projects whose PI is greater than 1 (one) i.e. Accept if PI > 1 Reject if PI < 1

45. Profitability Index (PI) Technique  Advantages of PI a. It recognizes the time value of money b. It is a variation of the NPV method and requires the same computation as in the NPV method c. It is a relative measure of a project’s profitability since the present value of cash inflows is divided by the initial cash outflow. d. It is generally consisted with the wealth maximization principle

46. Profitability Index (PI) Technique  Disadvantages of PI a. It can only be used to choose projects under simple, one period, capital constraint situations. b. It does not work when mutually exclusive projects or dependent projects are being considered.

47. Discounted Payback Period Technique (DPPT)  This technique is an improvement over the payback method.  It is aimed at overcoming the problem of the time value of money disadvantage of the normal payback method, by incorporating into its calculation, the discount factor.  In the discounted payback period method, the cash flows are discounted and used in the calculation of the payback period.

48. Discounted Payback Period Technique (DPPT)  Advantages of Discounted Payback Period Technique a. It recognizes the time value of money b. It focuses on shortness of project to payback the initial outlay c. In addition to the fact that it recognizes the time value of money it has all the advantages of the payback method.

49. Discounted Payback Period Technique (DPPT)  Disadvantages of Discounted Payback Period Technique a. It does not take into account the cash inflows earned after the payback period. b. It does not take into account the risks associated with each project and the attitude of the company to risk c. Except that it uses discounted cash flows, it has all the disadvantages of payback method.