1. Chapter 21 Information for capital expenditure decisions
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2. Outline Capital expenditure decisions
The capital expenditure approval process
Techniques for analysing capital expenditure projects
Other issues in capital expenditure analysis
Income taxes and capital expenditure analysis
Investments in advanced technologies
Post-completion audits
The limitations of capital expenditure analysis
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3. Capital expenditure decisions
Long-term decisions requiring the evaluation of cash inflows and outflows over several years to determine the acceptability of the project
Significant impact on the competitiveness of the business
Focus on specific projects and programs
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4. The capital expenditure approval process
Project generation
Often initiated by managers in business units
Consistent with strategic plan and corporate guidelines
Managers may use their discretion and not submit projects that may be acceptable to the business, but which may pose some risk for their business unit
Evaluation and analysis of projected cash flows
Over the life of the project
Difficult to detect biases in estimates of cash flows
Business unit managers may have the best knowledge of their business and market
(cont.)
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5. The capital expenditure approval process (cont.)
Progress to approval
The larger the project, the higher the level of authority for final approval
A political process may take place due to strong competition for project approval
Initiators need to justify and ‘sell’ their project
Analysis and selection of projects by corporate management
Implementation of projects
Post-completion audit of projects
Evaluation of accuracy of the initial plan and cash flows
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6. Techniques for analysing capital expenditure proposals
Consider costs and benefits of the project over several years
Cash outflows
The initial cost of the project and operating costs over the life of the project
Cash inflows
Cost savings and additional revenues, and any proceeds from the sale of assets that result from a project
(cont.)
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7. Techniques for analysing capital expenditure proposals (cont.)
Payback method
Accounting rate of return
Discounted cash flow (DCF) techniques
DCF techniques explicitly consider the time value of money
Makes future cash flows equivalent to those in the current year
Types of DCF methods include net present value (NPV) and internal rate of return (IRR)
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8. Net present value method
Calculates the present value of future cash flows of a project
Steps
Determine cash flows for each year of the proposed investment
Calculate the net present value (NPV) of each cash flow using the required rate of return
Calculate the NPV in total
Project is acceptable on financial grounds if NPV is positive
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10. Internal rate of return (IRR) method
Actual economic return earned by the project over its life
The discount rate at which the NPV of the cash flows is equal to zero
Steps
Determine cash flows for each year of the proposed investment
Calculate the IRR
If IRR is greater than the required rate of return, the project is acceptable on financial grounds
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12. Comparing the NPV and IRR methods
NPV has many advantages over IRR
Easier to calculate manually
Adjustments for risk possible under NPV
NPV will always yield only one answer
NPV overcomes unrealistic reinvestment assumption associated with IRR
Reinvestment assumption
Cash flows available during the life of a project are assumed to be reinvested at the same rate as the project’s rate of return
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13. Assumptions underlying discounted cash flow analysis
Two important assumptions
The year-end timing of cash flows
The certainty of cash flows
Determining required rate of return
Usually based on the firm’s weighted average cost of capital
Can be adjusted to take account of the risk of a particular project
Depreciation expense is not a cash flow
the purchase of an asset is cash outflow and the sale of an asset is a cash inflow
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14. Least-cost decisions
A capital expenditure project may be approved even when it yields a negative NPV (or less than the acceptable IRR)
Strategic concerns may be driving the investment
In a least-cost decision, we aim to minimise the NPV of the costs to be incurred rather than maximise the NPV of the cash flows
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15. Comparing two alternative investment projects
NPV and IRR may give different rankings for alternative projects
Due to reinvestment assumption of IRR
NPV results in correct ranking
Cannot always compare the NPVs from different projects, as projects may not have the same life
Strategic and competitive concerns must be considered in any decision
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16. Profitability index
Profitability index (or excess present value index)
Another method for comparing investment proposals
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17. Other techniques for analysing capital expenditure proposals
Payback method
The amount of time it will take for the cash inflows from the project to accumulate to cover the original investment
No consideration of the time value of money
Payback period
= Initial investment ÷ annual cash flow
The simple formula will not work if a project has uneven cash flow patterns
Use cumulative cash flows to determine payback
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18. Payback: the pros and cons
Two drawbacks
Ignores the time value of money
Ignores cash flows beyond the payback period
Widely used for several reasons
Simplicity
Useful for screening investment projects
Cash shortages may encourage short payback
Provides some insight as to the risk of a project
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19. Accounting rate of return method
Focuses on the incremental accounting profit that results from a project
Accounting rate of return
= Average annual profit from project ÷ initial investment
Accounting rate of return is, effectively, an average annual ROI for an individual project
The accounting rate of return method
Simple way to screen investment projects
Consistent with financial accounting methods
Consistent with profit-based performance evaluation
However, it ignores the time value of money
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20. Other issues in capital expenditure analysis
Where cash flow projections are uncertain, managers may
Increase the required rate of return
Use sensitivity analysis to determine how much cash flow estimates would need to change for a decision to not be supported
Potential conflict between the criteria for evaluating individual projects and those used to evaluate the overall performance of managers
A manager may reject a project with a positive NPV if it will reduce divisional profits in the early years of the project
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21. Income taxes and capital expenditure analysis
In profit-seeking enterprises, income taxes are usually payable
Taxation payments and tax deductions must be considered in any cash flows used in a capital expenditure proposal
After-tax cash flows
Cash flows after all the tax implications have been taken into account
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22. After-tax cash flows Tax effect of an increase in sales
Consider incremental revenue and costs arising from a capital expenditure decision
= (incremental sales revenue less COGS ) x (1-tax rate)
Tax effect of additional expenses
= incremental expense × (1 – tax rate)
Non-cash expenses, such as depreciation are not cash flows but can produce tax savings and hence may reduce cash outflows
Some cash flows do not appear on the income statement in the same period in which they occur
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23. Depreciation and cash flows
Australian taxation laws allow two methods of depreciation
Straight line (or prime cost)
Diminishing value, based on written-down value of the asset
The method used will affect the after-tax cash flow projections
The impact of a capital expenditure project on cash flows will result from taxation depreciation, not accounting depreciation
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24. Other cash flow issues arising from taxation
Profits or losses on disposal of assets have tax effects and, therefore, affect cash flows
Use the carrying amount resulting from taxation deprecation to calculate profit/loss on disposal
The carrying amount is an asset’s acquisition cost minus the accumulated depreciation
Investment allowances also affect cash flows in the year of purchase of an asset
Working capital may increase due to higher accounts receivable or inventory needed to support a capital investment project, and these are cash outflows
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25. Investments in advanced technologies
High-technology projects may yield negative NPVs, even when managers know the project will provide a competitive edge
Difficult to quantify strategic impact of investments
Relevant benefits and costs arising from investing in advanced technologies
Strategic implications of such investments
Intangible benefits derived from the investment
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27. Post-completion audits of capital expenditure decisions
Reviews a past capital expenditure project by analysing the actual cash flows generated and comparing them with the expected cash flows
Helps managers
Undertake periodic assessments of outcomes
Make adjustments where necessary
Control cash flow fluctuations
Assess rewards for those involved
Identify under-performing projects
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28. The limitations of conventional capital expenditure analysis
Use of unrealistic status quo
Assumes that current cash flows will be maintained if the project does not go ahead
Need to compare the cash flows of the new proposal to the reduction in cash flows that will occur if the project does not proceed
Hurdle rates may be too high
Time horizons may be too short
Need to include benefits over all future years to prevent bias against unfavourable projects
(cont.)
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29. The limitations of conventional capital expenditure analysis (cont.)
Difficulty in gaining approval for large projects may create incentives for managers to propose small projects
Advanced technologies may entail greater uncertainty about operating cash flows
Some benefits that are difficult to quantify may be excluded from the analysis
Synergistic effects of multiple capital expenditure proposals
Greater flexibility in the production process
Shorter cycle times and reduced lead times
Reduction of non-value-added costs
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30. Summary
Capital expenditure analysis entails projecting future cash flows over several time periods and evaluating against required rates of return
Discounted cash flow methods, such as NPV and IRR, take account of the time value of money
When comparing alternative projects NPV and IRR do not always give the same ranking, particularly where the projects have unequal lives
The payback or accounting rate of return methods may also be used to evaluate projects
(cont.)
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31. Summary (cont.)
Where income taxes are payable, the after-tax cash flows must be taken into account in any capital expenditure analysis
DCF techniques may be used to evaluate investments in advanced technologies, but they may not always yield positive outcomes due to the difficulties in quantifying strategic and intangible issues
Post-completion audits may be used to evaluate the outcomes of capital expenditure projects
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