Capital Expenditure Appraisal

• Cash Flow - revisited

• Accounting Rate of Return
• Payback Period
• DCF Techniques
• Net Present Value
• Sensitivity Analysis

©A. Ward 2002

 Cash Flow Profile

Major long-term capital investment project.

Net 80
Cash 60
Flow
40
20
0
Time
-20
-40
-60 Investment
-80 Return

©A. Ward 2002

 Cash Flow Profile

Periodic replacement with increasing prices.

Net 150
Cash
Flow 100

50

0 Time

-50

-100
Investment
-150 Return

©A. Ward 2002

 Cash Flow Profile

Investment with cyclical cash flows

Net 80
Cash 60
Flow
40
20
0
Time
-20
-40
-60 Investment
-80 Return

©A. Ward 2002

 Capital Expenditure - Definition

“Funds spent in the expectation of securing a

stream of benefits, which may take some time to
start flowing and which may last for some years.”
The amount spent is very often substantial.

©A. Ward 2002

 Capital Expenditure - Examples

• Purchase of Plant or Machinery

• Purchase of Land
• Development of a New Product
• Installation of a New Computer System
• etc.

©A. Ward 2002

 Capital Expenditure Appraisal -
Objectives

• whether a particular capital expenditure

proposal is justified in terms of the
expected benefits
• if there are alternative proposals which
should be undertaken

©A. Ward 2002

 Analysis of Options - Example

Project A Project B Project C

Initial Cost (£) 100000 100000 100000

Expected Cash Inflow (£)

Year 1 15000 30000 30000

Year 2 25000 30000 30000
Year 3 30000 30000 30000
Year 4 30000 30000 30000
Year 5 30000 25000 0
Year 6 30000 15000 0

Total 160000 160000 120000

©A. Ward 2002

 Accounting Rate of Return

• Surplus = Cash Inflow - (Initial Investment - Residual Value)

• Average Investment = (Initial Investment - Residual Value)/2

©A. Ward 2002

 Cash Inflow Stream

• Total net cash flow is identical

• Pattern of cash inflow is different
• There is less risk associated with cash
received early, compared to that received
later
• The earlier that cash is received the quicker
it can be recycled into new cash generating
ventures (or used to pay-off debts)
• Accounting Rate of Return ignores the time
value of money.

©A. Ward 2002

 Payback Period (Breakeven)

Recognises the time value of money

©A. Ward 2002

 Limitations

• Accounting Rate of Return

- Ignores the time value of money
• Payback Period
- Ignores cash after Breakeven
• There has to be a better way! There is!

©A. Ward 2002

 Discounted Cash Flow (DCF)

• Basic Principle is that the value of money changes with

time.
Example :
£100 invested at 10% interest rate
is worth £110 in 1 year, £121
Thus £100 now is worth just the same as £121 next year

• Based on Investment Criteria - ignore risk & inflation

©A. Ward 2002

 Discounted Cash Flow (DCF)

• Decision :
• Is it worth making a £100 “investment”
now to generate a £130 of future value at
the end of 2 years?
• To answer we need to make a Net Present
Value calculation

©A. Ward 2002

 Net Present Value (NPV)

• Given an interest rate of 10% what investment now will give

a future value of £130 in 2 years time?

? invested now is worth ?*(1+0.1) in 1 years time

?*(1+0.1) becomes worth ?*(1+0.1)*(1+0.1) in 2 years time
Hence ?*(1+0.1)*(1+0.1) = £130
? = £107.44

©A. Ward 2002

 Net Present Value (NPV)

• In General
• The Net Present Value of a return of £P in n years time with
a prevailing interest rate of r% is given by:

P
NPV 
(1  r )^ n
• Solve by spreadsheet or Discount Tables
• Note this ignores future inflation rates. The model allows for
varying interest rates per year.

©A. Ward 2002

 Discount Factors

Years 1 2 3 4 5 6 7 8 9 10
1% 0.990099 0.980296 0.97059 0.96098 0.951466 0.942045 0.932718 0.923483 0.91434 0.905287
2% 0.980392 0.961169 0.942322 0.923845 0.905731 0.887971 0.87056 0.85349 0.836755 0.820348
3% 0.970874 0.942596 0.915142 0.888487 0.862609 0.837484 0.813092 0.789409 0.766417 0.744094
4% 0.961538 0.924556 0.888996 0.854804 0.821927 0.790315 0.759918 0.73069 0.702587 0.675564
5% 0.952381 0.907029 0.863838 0.822702 0.783526 0.746215 0.710681 0.676839 0.644609 0.613913
6% 0.943396 0.889996 0.839619 0.792094 0.747258 0.704961 0.665057 0.627412 0.591898 0.558395
7% 0.934579 0.873439 0.816298 0.762895 0.712986 0.666342 0.62275 0.582009 0.543934 0.508349
8% 0.925926 0.857339 0.793832 0.73503 0.680583 0.63017 0.58349 0.540269 0.500249 0.463193
9% 0.917431 0.84168 0.772183 0.708425 0.649931 0.596267 0.547034 0.501866 0.460428 0.422411
10% 0.909091 0.826446 0.751315 0.683013 0.620921 0.564474 0.513158 0.466507 0.424098 0.385543
11% 0.900901 0.811622 0.731191 0.658731 0.593451 0.534641 0.481658 0.433926 0.390925 0.352184
12% 0.892857 0.797194 0.71178 0.635518 0.567427 0.506631 0.452349 0.403883 0.36061 0.321973
13% 0.884956 0.783147 0.69305 0.613319 0.54276 0.480319 0.425061 0.37616 0.332885 0.294588
14% 0.877193 0.769468 0.674972 0.59208 0.519369 0.455587 0.399637 0.350559 0.307508 0.269744
15% 0.869565 0.756144 0.657516 0.571753 0.497177 0.432328 0.375937 0.326902 0.284262 0.247185
16% 0.862069 0.743163 0.640658 0.552291 0.476113 0.410442 0.35383 0.305025 0.262953 0.226684
17% 0.854701 0.730514 0.624371 0.53365 0.456111 0.389839 0.333195 0.284782 0.243404 0.208037
18% 0.847458 0.718184 0.608631 0.515789 0.437109 0.370432 0.313925 0.266038 0.225456 0.191064
19% 0.840336 0.706165 0.593416 0.498669 0.419049 0.352142 0.295918 0.248671 0.208967 0.175602
20% 0.833333 0.694444 0.578704 0.482253 0.401878 0.334898 0.279082 0.232568 0.193807 0.161506

©A. Ward 2002

 Net Present Value of a Cash
Stream

To handle a regular or periodic cash stream (in or out):

• Determine the periodic cash flow

• Convert each cash flow to the net present
value
• Sum all present values to give Net Present
Value of Stream

©A. Ward 2002

 NPV Example

Project A Project B Project C

Initial Cost (£) 100000 100000 100000

Expected Cash Inflow (£)

Year 1 15000 30000 30000

Year 2 25000 30000 30000
Year 3 30000 30000 30000
Year 4 30000 30000 30000
Year 5 30000 25000 0
Year 6 30000 15000 0

Total 160000 160000 120000

©A. Ward 2002

 NPV Example

Year 0 1 2 3 4 5 6
DCF 1 0.892857 0.797194 0.71178 0.635518 0.567427 0.506631

Project A -100000 15000 25000 30000 30000 30000 30000

PV -100000 13392.86 19929.85 21353.41 19065.54 17022.81 15198.93
NPV 5963.393

Project B -100000 30000 30000 30000 30000 25000 15000

PV -100000 26785.71 23915.82 21353.41 19065.54 14185.67 7599.467
NPV 12905.62

Project C -100000 30000 30000 30000 30000

PV -100000 26785.71 23915.82 21353.41 19065.54 0 0
NPV -8879.52

©A. Ward 2002

 Sensitivity Analysis

• Capital Expenditure Proposals involve

assumptions
• Each Assumption can be tested
• The sensitivity of the IRR or NPV can be
determined for each assumption

©A. Ward 2002

 Sensitivity Analysis - Example

Consider a +/-10% change in initial cost of project

Year 0 1 2 3 4 5 6
DCF 1 0.892857 0.797194 0.71178 0.635518 0.567427 0.506631

Project B -100000 30000 30000 30000 30000 25000 15000

PV -100000 26785.71 23915.82 21353.41 19065.54 14185.67 7599.467
NPV 12905.62 IRR 16.81%

Project B -110000 30000 30000 30000 30000 25000 15000

PV -110000 26785.71 23915.82 21353.41 19065.54 14185.67 7599.467
NPV 2905.619 IRR 13.00%

Project B -90000 30000 30000 30000 30000 25000 15000

PV -90000 26785.71 23915.82 21353.41 19065.54 14185.67 7599.467
NPV 22905.62 IRR 21.31%

©A. Ward 2002

 Sensitivity Analysis - Example

Consider the effect of a year delay in sales

Or 1 year delay in entire project

Year 0 1 2 3 4 5 6 7
DCF 1 0.892857 0.797194 0.71178 0.635518 0.567427 0.506631 0.452349

Project B -100000 30000 30000 30000 30000 25000 15000

PV -100000 26785.71 23915.82 21353.41 19065.54 14185.67 7599.467
NPV 12905.62 IRR 16.81%

Project B -100000 0 30000 30000 30000 30000 25000 15000

PV -100000 0 23915.82 21353.41 19065.54 17022.81 12665.78 6785.238
NPV -5976.65 IRR 12%

Project B -100000 30000 30000 30000 30000 25000 15000

PV 0 -89285.7 23915.82 21353.41 19065.54 17022.81 12665.78 6785.238
NPV 4737.636 IRR 17%

©A. Ward 2002

 Sensitivity Analysis - Example

Consider interest rate changes

Interest Rate NPV

5% 37159.90
6% 33209.03
7% 29436.13
8% 25830.93
9% 22383.89
10% 19086.11
11% 15929.27
12% 12905.62
13% 10007.92
14% 7229.38
15% 4563.68

©A. Ward 2002