1. 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)

2. 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

3. 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)

4. 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.

5. 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

6. 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

7. 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

8. 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

9. 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

10. 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

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

12. Net Present Value (NPV)
Year
Cash flows
Discount factor
Present value 1
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

13. Net Present Value (NPV)
Example 1
NPV=( )
= =
The investment is profitable with these presumptions

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

15. Net Present Value (NPV)
Year
Cash flows
Discount factor
Present value 1
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

16. Net Present Value (NPV)
Example 2:
NPV =( ) –
= =
Investment is not profitable anymore

17. 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

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

19. 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

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

21. The Payback Period (PP)
Years 1 2 3 4 5
Project’s
cash flows
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
= – ( ) =
PP = ( / ) = years

22. 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