1. Topic 6: Evaluating Capital expenditure Decisions
Topic 7: Evaluating Further aspects of Investment Decisions
Reference: Chapter 21 Information for capital expenditure decisions Slides adapted from Langfield-Smith et al., McGraw-Hill

2. Learning Outcome: - Evaluate the nature and purpose of capital expenditure decisions. - Interpret a typical capital expenditure approval process. - Evaluate the importance of, and account for, the time value of money in capital expenditure decisions. -Validate the different capital budgeting techniques and criterions to evaluate the capital proposals and select the best decisions -Formulate the appropriate techniques to select the least –cost decision in capital expenditure analysis. -Evaluate the use of sensitivity and scenario analysis to account for uncertainty of cash flows. -Interpret the potential conflict between using discounted cash flow analysis for evaluating capital expenditure projects and using accrual accounting data for evaluating a manager’s performance. -Evaluate the after tax cash flows in a capital expenditure analysis.

3. Capital expenditure decisions
Long-term decisions requirements to determine the acceptability of the project
Significant impact on the competitiveness of the business
Focus on specific projects and programs
Cost inflows need to exceed cost outflows to justify the project
Qualitative and strategic issues
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. Management must decide if the project is worthwhile, if funds are in the budget.
Cost inflows need to exceed cost outflows to justify the project, but qualitative and strategic issues are also important considerations

4. Cash flows
Consider costs and benefits of the project or alternative projects over several years
Cash outflows
Cash inflows
Techniques to analyse cash flows
Payback method and accounting rate of return
Discounted cash flow (DCF) techniques
Consider costs and benefits of the project or alternative projects over several years
Cash outflows
Includes the initial cost of the project and any increase in costs incurred, over the life of the project
Cash inflows
Cost savings and additional revenues, and any proceeds from the sale of assets, over the life of the project
Techniques to analyse cash flows
Payback method and accounting rate of return
Discounted cash flow (DCF) techniques
Neither of these methods consider the effect of the time value of money

5. The capital expenditure approval process
1. Project generation
Often initiated by business unit managers
Consistent with strategic plan and corporate guidelines
Managers may not submit projects that may be acceptable to the business, but which may pose some personal risk or risk for their business unit
Project generation
Often initiated by managers in business units
Consistent with strategic plan and corporate guidelines
Managers may not submit projects that may be acceptable to the business, but which may pose some personal risk or risk for their business unit
Estimation 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.)

6. 2. Estimation 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

7. The capital expenditure approval process (cont.)
3. Progress to approval
The level of authority for final approval
internal competition for limited resources
Initiators need to justify and ‘sell’ their projects to senior management
4. Analysis and selection of projects by senior management
5. Implementation of projects
6. Post-completion audit of projects
Progress to approval
The higher the project cost, the higher the level of authority for final approval
There may be strong internal competition among business unit managers for limited resources
Initiators need to justify and ‘sell’ their projects to senior management
Analysis and selection of projects by senior management
Implementation of projects
Post-completion audit of projects
Evaluation of accuracy of the initial plan and cash flows

8. Discounted cash flow (DCF) analysis
In analysing project cash it is incorrect to add them all together over several years
A $100 cash flow today is not the same value in five years’ time
DCF techniques explicitly consider the time value of money
Allows future cash flows to be discounted so they are equivalent to those in the current year
Types of DCF methods
In analysing cash inflows and outflows associated with a project that extend over several years, it is incorrect to add them all together
A $100 cash flow today is not equivalent to $100 cash inflow received in five years time
DCF techniques explicitly consider the time value of money
Allows future cash flows to be discounted so they are equivalent to those in the current year
Types of DCF methods include net present value (NPV) and internal rate of return (IRR)

9. Net present value method (NPV)
Calculates the present value of the 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
(cont.)

10. Net present value method (NPV) (cont.)
Exhibit 21.3
The net present value analysis indicates that the purchase of the additional scanner ($ ) would yield cost savings or additional revenue (with a present value of $ ), which exceeds the new machine’s acquisition cost. The net present value of the cash inflows exceeds the cash outflows by $ Thus, the NPV analysis favours the purchase of the additional machine.

11. Internal rate of return (IRR) method
Actual economic return earned by the project over its life
The IRR is 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
To calculate the IRR using a financial calculator or a software program
(cont.)

12. Internal rate of return (IRR) method (cont.)
Exhibit 21.4
The internal rate of return can be calculated by solving for r in the following formula:
p n = += tt n C r1 1 ()
where p = initial outlay
Ct = net cash flow generated by the project in period t
n = life of the project
r = the internal rate of return
Of course, the easy way to find the exact internal rate of return is to use a financial calculator, or a software program such as Microsoft Excel®. The correct internal rate of return is the rate for which the net present value is zero. Exhibit 21.4 shows that when the discount rate is 12 per cent, the NPV for the proposed investment is zero. Thus, the internal rate of return for Alternative One, the purchase of the additional CT scanner, is 12 per cent.
The decision under IRR
Now that we know that the investment proposal’s internal rate of return is 12 per cent, how can the Meadowleigh Medical Centre use this information in its decision?
An investment proposal is acceptable on financial grounds if its internal rate of return is greater than the required rate of return. The internal rate of return of the proposal, 12 per cent, exceeds the hospital’s required rate of return, 10 per cent. Thus, the discounted cash flow analysis supports the purchase of the additional CT scanner.

13. Determining the required rate of return
The required ROR is usually based on the organisation’s weighted average cost of capital
The cost of capital is the minimum return needed to compensate suppliers of capital for committing resources to a project
To evaluate projects, the weighted average cost of capital may be adjusted
The required ROR is usually based on the organisation’s weighted average cost of capital
The cost of capital is the minimum return needed to compensate suppliers of capital for committing resources to a project
To evaluate projects, the weighted average cost of capital may be adjusted for risk associated with a particular project

14. Depreciable assets
When a long-term asset is purchased, the acquisition cost is an expense (depreciation) over several time periods
In capital expenditure analysis, the acquisition cost is a cash outflow in the year in which it is expended
Depreciation expense is not a cash flow so is not included in capital expenditure analysis
Note: The acquisition cost as a cash flow in the analysis, but do not record the annual depreciation expenses – they are not relevant to our discounted cash flow analysis.

15. 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 the unrealistic reinvestment assumption associated with IRR
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 the 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
A further disadvantage of IRR compared with NPV relates to the ranking of projects. The use of IRR can lead to sub-optimal decisions compared with decisions made using the NPV method. This issue is discussed in a later section of this chapter.
In general, the NPV technique is usually regarded as superior to the IRR technique when evaluating capital investment proposals.

16. 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 decision
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
Examples where a least-cost decision may be taken include the purchase of safety equipment, or expenditure on equipment that is needed to satisfy environmental standards, such as emission control or waste disposal.

17. 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
(cont.)

18. Comparing two alternative investment projects (cont.)
Exhibit 21.6
displays a net present value analysis of the two alternatives. The net present value of purchasing an additional CT scanner is compared with that of replacing the old machine. While the NPV of both alternatives is positive, Alternative One yields an NPV that is greater than Alternative Two.
We have already calculated the IRR of Alternative One as 12 per cent. Given the low positive NPV of Alternative Two ($2335 in Exhibit 21.6), we can predict that its IRR will be close to 10 per cent. The IRR for Alternative Two is per cent. This can be checked by estimating the net present value of the cash flows with this discount rate and finding that it is equal to zero.
We now have the financial information that the project director needs for her report. The discounted cash flow analyses support the purchase of the additional scanner, while the replacement alternative was very close to the required rate of return:
Alternative One Alternative Two
NPV (at 10%) $ $2335
IRR % %
Refer to the case study in the textbook for a complete analysis

19. Profitability index
Profitability index (or excess present value index) defined as
Another method for comparing investment proposals
The profitability indices for MMCs two proposals are calculated as follows:
Investment proposal Calculation Profitability index Net present value Internal rate of return
Original Model $ /$ = $ %
New Model $ / $ = $ %
In this analysis, the original model has a slightly lower profitability index but has a higher NPV, while the new model has the higher IRR. Unfortunately, the profitability index suffers from the same drawbacks as those associated with the NPV or IRR methods. Both proposals exhibit a profitability index greater than 1.00, which merely reflects their positive NPVs. Thus, both projects are desirable. The unequal lives of the two proposals means that the profitability index cannot be used to determine a reliable ranking of the proposals. The relative desirability of either proposal depends on what will happen in years 4 to 5 if the new model CT scanner with the shorter life is selected.

20. 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
The simple formula will not work if a project has uneven cash flows
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 flows
Use cumulative cash flows to determine payback

21. Payback: the pros and cons
Two drawbacks
Ignores the time value of money
Ignores cash flows after 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

22. 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, averages the annual ROI for an individual project
The accounting rate of return method
Pros and cons of the ARR 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
ARR = average annual profit from the project/initial investment however some managers prefer to calculate the ARR using the average amount invested in a project for the denominator, rather than the project’s full cost
The accounting rate of return method
Simple way to screen investment projects
Consistent with financial accounting methods
Consistent with profit-based performance evaluation
Four advantages of the accounting rate of return method, compared with other techniques, are as follows:
1 Screening investment projects. Like the payback method, the accounting rate of return method is a simple way of screening investment proposals.
2 Consistency with financial accounting methods. Some managers use this method because it parallels financial accounting statements, which are also based on accrual accounting.
3 Consistency with profit-based performance evaluation systems. Unlike discounted cash flow methods, there is consistency between the accounting rate of return method and accounting-based performance measures, such as return on investment. This issue is discussed later in the chapter.
4 Consideration of the entire life of the project. Unlike the payback method, the accounting rate of return method considers the entire life of the project.
A disadvantage of the ARR, like the payback method, is that it does not consider the time value of money

23. 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

24. After-tax cash flows Tax effect of an increase in sales
= (incremental sales revenue less COGS ) x (1 – tax rate)
Tax effect of additional expenses
= incremental expense × (1 – tax rate)
Non-cash expenses
Cash flows do not appear on the income statement in the same period in which they occur

25. Depreciation and cash flows
Most commonly, taxation laws allow two methods of depreciation
Straight line (or prime cost)
Diminishing value
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
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

26. Other cash flow issues arising from taxation
Profits or losses on disposal of assets have tax effects and, therefore, affect cash flows
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
Causes of working capital increases
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

27. Post-completion audits of capital expenditure decisions
Reviews a past capital expenditure project by comparing the project’s actual cash flows with the projected cash flows
Helps managers
Provide feedback on the accuracy of initial estimates for the project
Undertake periodic assessments of outcomes
Control cash flow fluctuations
Assess rewards for those involved
Identify under-performing projects

28. Justifying 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
(cont.)

29. Summary
Capital expenditure analysis project and analyse future cash flows over several time periods
Discounted cash flow methods, NPV and IRR, include the time value of money
When comparing alternative projects with unequal lives, NPV and IRR do not always give the same ranking
The payback or ARR methods may also be used to evaluate projects, but do not take account of the time value of money
(cont.)

30. Summary (cont.)
Where applicable, the after-tax cash flows must be taken into account in any capital expenditure analysis
Post-completion audits can evaluate the outcomes of capital expenditure projects, and provide feedback for managerial learning
DCF techniques can evaluate investments in advanced technologies, but may not yield positive outcomes due to the difficulties in quantifying strategic and intangible issues