1. Capital expenditure Decisions
Session 1

2. Meaning
Corporate finance is strategic in nature and can be viewed from three angles
How a firm finances its investments ( capital structure decisions)
How it manages short-term financial requirements (working capital decisions)
The allocation of funds (capital expenditure decisions)

3. Capital expenditure Decisions
Is the process of making investment decisions in capital expenditure.
It is long term planning for making and financing proposed capital outlays.
It is concerned with the allocation of the firm’s scarce financial resources among the available market opportunities
These involve selecting the best from various mutually exclusive projects
that require current outlay of funds in the expectation of future stream of benefits extending far into future
Outlay means outflow or investment
Benefits mean inflows or income generating out of the investment

4. Features Overall objective is to
Require long term commitment of funds
Has long term effect on profitability
substantial outlays
Difficult and expensive to reverse
Difficulties of Investment decisions because
Decision extends to a series of years beyond the current accounting period
Uncertainties of future
Higher degree of risk
Overall objective is to
maximize the profitability of a firm or the return on investment
(Either by increasing revenue or decreasing the costs)

5. Types Mandatory investments Accept/ Reject Replacement Projects
Examples
Grouping
Mandatory investments
Replacement Projects
Expansion Projects
Diversification Projects
Research and Development Projects
Miscellaneous Projects
Accept/ Reject
Mutually Exclusive Project Decisions
Capital Rationing Decisions

6. Steps Identification of Potential Investment Opportunities
Assembling of Investment Proposals
Replacement, Expansion, New Product, Obligatory and welfare
Decision Making
Preparation of Capital Budget and Appropriations
Implementation
Performance Review

7. Project evaluation Techniques
Traditional
Pay back period
ARR
Modern
NPV
BCR
IRR
ACC

8. TRADITIONAL METHODS – Pay Back period
Pay back period means the length of time required to recover the initial cash outlay on the project
The shorter the payback period, the more desirable the project is
Seen under two situations
Projects with EVEN CASH FLOWS
Projects with UNEVEN CASH FLOWS
Accept/reject criteria: accept the project with shorter payback periods

9. Pay back period = Cash Outlay Annual cash inflows
For even cash flows
Pay back period = Cash Outlay
Annual cash inflows
For uneven cash flows ( if the outlay is 1,00,000) Y
Cash inflow of A
Cash inflow of B 1
50,000
20,000 2
30,000 3 4
10,000
40,000 5 6 -
60,000
Pay back period of A = = 1 Lakh
= 3yrs
Pay back period of B = = 1Lakh
= 4 yrs

10. Alternatively --- Determine the cumulative cash inflows Year A inflow
Cum inflow
B inflow 1
50,000
20,000 2
30,000
80,000,
40,000 3
1,00,000
60,000 4
10,000
1,10,000 5
1,20,000
1,50,000 6 -
2,10,000
Locate the year against which 1,00,000 appears
That is the pay back period
The project with shorter pay back period is selected, here it is A

11. Example 2 A project cost Rs 5,00,000 and yields annually a profit of Rs 80,000 after 12% p.a but before tax and depreciation if 50%. Calculate the pay back period.
Profit before tax & Depreciation = 80,000 Less Depreciation = 60,000 Profit before tax = 20,000 Less 50% = 10,000 Profit after tax = 10,000 Add 12%on 5,00,000 = 60,000 70,000 Pay back period = Cost of the project = 5,00,000 = 7.14 years Annual Cash flow 70,000

12. Disadvantages Advantages Fails to consider TMV Simple
Does not consider projects which generate inflows substantially after the pay back period
It treats each asset/project in isolation
Does not measure the true profitability as the period considered is very short, but the life of the asset/project is very long
Does not take cost of capital into consideration
Advantages
Simple
Rough and ready method to weed out risky projects the cash inflows of which is more after the pay back period
Emphasis on cash inflows so useful for firms with liquidity crises
Useful while evaluating a single project.

13. Improved pay back period methods
Post Pay-back profitability method
Pay-back Reciprocal method
Post-Pay back period method
Discounted Pay-Back method

14. Post Pay-back profitability method
Step 1 Calculate Post Pay back profitability
= Annual cash inflow ( Estimated life – Pay back period)
Step 2 Calculate Post Pay back Profitability Index
= (PPP / initial investment)*100
Pay-back reciprocal method
= Annual Cash inflow / total investment
This is used to estimate the internal rate of return generated by a project
Post pay back period
The project with greatest post pay-back period is accepted because it continues to generate revenue to the firm

15. Illustration
Calculate the discounted pay-back period method from the following information Cost of the project = Rs 6,00,000 Life of the project = 5 years Annual Cash Inflow = 2,00,000 Cut off rate 10 %

16. Discounted Payback method
Year
Cash flow
Discounting factor
Present value
Cumulative discounted
Net cash flow 1
2,00,000
0.909
1,81,800 2
0.826
1,65,200
3,47,000 3
0.751
1,50,200
4,97,200 4
0.683
1,36,600
6,33,800 5
0.621
1,24,200
7,58,000
The outlay of Rs 6,00,000 will be recovered between the 3rd and the 4th years
Precisely = 3 years + 1,02,800
1,36,600
= 3 ¾ years

17. Average/Accounting Rate of Return
It is the average profit after tax divided by the average book value of the investment over the life of the project
ARR = Average annual Profit after Tax
Net Average Investment
In order to calculate profit after tax
From profit, deduct
Depreciation
Interest
Tax
Add depreciation ( As depreciation is a non-cash item )
Accept/reject Criteria: Accept Project with higher ARR

18. Net investment = Rs 5,00,000 – 20,000 = Rs. 4,80,000
Illustration: A project requires an investment of Rs 5,00,000 and has a scrap value of Rs 20,000 after five years. It is expected to yield profits after depreciation and taxes during the five years amounting to Rs. 40,000, Rs. 60,000, Rs.70,000, Rs.50,000 and Rs. 20,000. Calculate the average rate of return on the investment.
Total Profit = = 2,40,000
Average profit = 2,40,000 = Rs. 48,000 5
Net investment = Rs 5,00,000 – 20,000 = Rs. 4,80,000
ARR = 48, * 100
4,80,000
= 10%

19. X Ltd is considering the purchase of machine
X Ltd is considering the purchase of machine. Two machines are available E and F. The cost of machine is Rs.6,00,000. Each machine has an expected life of 5 years. Net profits before tax and after depreciation during the expected life of the machines are given below
Year
Machine E
Machine F 1
15,000
5,000 2
20,000 3
25,000 4
30,000 5
10,000
Total
85,000
90,000
Assume the tax rate to be 50%

20. Statement of Profitability
Year
Machine E
Machine F
PBT
TAX
PAT 1
15,000
7500
5,000
2500 2
20,000
10000
5000 3
25,000
12500 4
15000
30,000 5
10,000
85,000
42,500
90,000
45000
Av. PAT
Av. Invt
ARR
42500/5 = 8500
60,000/2 = 30,000
(8500/30000)*100 = 28.33%
45000/5 = 9000
(9000/30000)*100 = 30%
Machine F is more profitable than Machine E as the ARR is greater

21. Advantages
Simple
Based on accounting information available
considers the entire life of the project
Takes the average of the best estimate of profits
Disadvantages
Based on accounting profit and not cash flows
Does not take TMV
Does not provide any guidance on what target rate of return should be

22. Modern methods - Net Present Value
Refers to the sum of the present values of all the cash flow positive as well as negative
That are expected to occur over the life of the project
Since it discounts the cash flows, it is considered better than the traditional methods
The firms discount the cash flows at the cost of capital estimated previously for the components of capital involved in the project

23. Steps
Compute the cut-off rate, which is the cost of capital/minimum required rate of return for the providers of funds
Compute the present value of the total investment outlay
Compute the present value of the inflows at the cut-off rate ( cash inflows after depreciation and taxes)
Calculate the NPV which is PV of outflows – PV of inflows
accept /reject criteria: That project/asset which generates maximum positive NPV

24. Illustration If suppose a project has a life of 5 years and it requires an initial outlay of Rs Calculate its Net Present Value. Also find whether the project is worth investing.
Year
Cash inflows
Discount
Discounted cash flows 1
10000
0.909
9900 2
12000
0.826
9912 3
0.751
9012 4
14000
0.683
9562 5
15000
0.621
9315
The sum of present values = = Rs
Since it is more than the initial outlay of Rs 35,000, it is worth investing in the project.

25. Advantages
Disadvantages
It recognizes the time value of money and is suitable to be applied in a situation with uniform cash outflows and uneven cash inflows or cash flows at different periods of time.
Takes into account the earnings over the entire life of asset/project
Takes into consideration the objective of maximum profitability
More difficult to understand and operate
May not give good results while comparing projects with unequal lives as the project having net present value but realized

26. Internal rate of return (IRR)
It is that rate of interest at which the net present value of a project is equal to zero
Or it is the rate which equates the present value of cash inflows with that of the outflows
In NPV, the cost of capital becomes the discount rate, in IRR, the discount rates which makes the NPV 0 has to be worked out
This is done usually with trial and error method

27. Steps to determine IRR
Find the average annual net cash flow from the given cash flows
Divide the initial outlay by the average annual net cash flow, the answer is the PVIFA factor
Look out for the interest rate against which the factor appears for the given life of the project
Multiply each of the cash flows by the PV values under the interest factor found earlier, through the life of the project
That factor for which the difference between the initial outlay and the sum of the discounted cash flows is zero is the IRR.
Accept/Reject criteria: Accept the project with IRR< k( WACC)

28. A company has the following pattern of cash flows
Year
Cash flows ( in lakhs)
(10) 1 5 2 3
3.08 4
1.20
Calculate the IRR

29. PVIFA = Initial outlay average annual cash flow 10 3. 57 {(5+5+3. 08+1
From the PVIFA table, the interest factor corresponding to four years is nearly 15%
Taking the base interest as 15%, we start trial and error method
At 15%, (-10 +(5*0.870)+(5*0.756)+(3.08*0.658)+(1.2*0.572) = 0.84
At 16%, (-10+(5*0.862)+(5*0.743)+(3.08*0.641)+(1.2*0.552) = 0.66
At18%, (-10+(5*0.848)+(5*0.719)+(3.08*0.609)+(1.2*0.516) = 0.33
At 20% (-10 +(5*0.833)+(5*0.694)+(3.08*0.579)+(1.2*0.482) = 0
So IRR is 20%

30. Benefit – Cost Ratio It is also referred to as Profitability Index
BCR = PV /I
PV stands for Present value of Future cash flows
I stands for Initial investment
NCBR = BCR -1
Accept/Reject criteria : BCR>1 or NCBR>0, Accept
BCR<1 or NCBR<0, Reject

31. Evaluation
The method is useful to rank a set of projects in the order of decreasingly efficient use of capital
It provides no means for aggregating several smaller projects into a package than can be compared with a large project
When the investment outlay is spread over more than one period, this criterion cannot be applied.

32. Zeta Ltd is considering the following projectsCf
NPV A
7.5
(7.5*3.433)-20 =5.75 B
1.5
(1..5*3.433)-4.5=0.65 C
2.5
(2.5*3.433) -7 = 1.58 D
3.5
(3.5*3.433)-8=4.02
PROJECTS
INITIAL OUTLAY
CASH INFLOWS A 20
7.5 B
4.5
1.5 C 7
2.5 D 8
3.5
PROJECTS
BCR A
25.75/20
1.27 B
5.15/4.5
1.14 C
8.58/7
1.23 D
12.02/8
1.50

33. Annual Capital Charge
Used for evaluating mutually exclusive projects or alternatives which provide similar service
Steps
First determine the PV of the initial investment and operating costs using the cost of capital (k) as the discount rate
Then, determine PVIFA using (k,n) in the table
Divide the PV of the cash flows by the PVIFA, the answer is annual capital charge
Accept/Reject criteria: Accept the project/asset with lesser Annual Capital Charge

34. Illustration