Capital Expenditure Decisions

Capital Expenditure Decisions

Discounting Non Discounting
Evaluation Criteria
Payback period
Accounting
Rate of Return
(ARR)
Net Present
Value
(NPV)
Internal
Rate of
Return
(IRR)
Profitability
Ratio/Benefit
Cost Ratio
( PI/BCR)
Net Present Value
)

+
=
n
t
t
t
c
k
c
NPV
1
0
1
)
) ) )
0
3
3
2
2 1
1
........
1 1
1
c
k
c
k
c
k
c
k
c
NPV
n
n

+
+
+
+
+
+
+
=
Where,
C
1,
C
2
represent the net cash inflow in year 1, 2
K is the opportunity cost of Capital
C
0
is the initial cost of investment
n is the expected life of investment
Net Present Value
Acceptance Rule NPV
Accept NPV > 0
Reject NPV < 0
May accept NPV = 0
Evaluation of NPV method
It recognizes the time value of money
It uses all cash flows occurring over the entire life of
the project
NPVs of the projects can be added
NPV(A+B)=NPV(A)+NPV(B)-Value Additively Principle
NPV method is consistent with the objective of
maximizing the shareholders wealth
Net Present Value
Year
Amount outstanding in the
beginning
Return on outstanding
amount at 10%
Total amount
outstanding flows
Repayment from
cash at the end
Balance
outstanding
Rs Rs Rs Rs Rs
1 2500 250 2750 900 1850
2 1850 185 2035 800 1235
3 1235 123.5 1358.5 700 658.5
4 658.5 65.85 724.35 600 124.35
5 124.35 12.435 136.785 500 -363.215
Internal Rate of Return
Acceptance Rule IRR
Accept r > k
Reject r < k
May accept r = k
Evaluation of IRR method
It recognizes the time value of money
It uses all cash flows occurring over the entire life of
the project
IRR method is consistent with the objective of
maximizing the shareholders wealth
)

+
=
n
t
t
t
c
r
c
1
0
1
0
Internal Rate of Return
Unlike in the case of NPV method, the value additivity
principle does not hold.
IRR method can yield multiple internal rates of return
Project C
0
C
1
NPV @ 10% IRR %
A -100 120 9.08 20%
B -150 168 2.712 12%
A+B -250 288 11.792 15.20%
Initial cost 0 -20,000
Net cash flow 1 90,000
Net cash flow 2 -80,000
IRR 21.9%, 228%
Conflict in ranking
Different rankings given by the NPV and IRR
methods can be illustrated under the following
heads:
Size-disparity problem
Time-disparity problem
Unequal expected lives
Size Disparity Problem
Particulars Project A Project B Project B - A
Cash outlays -5000 -7500 -2500
Cash inflows at the
end of the year, 1 6250 9150 2900
IRR (%) 25 22 16
k
NPV 681.25 817.35
10
Time Disparity Problem
C
0
C
1
C
2
C
3
NPV @ 9% IRR
M -1680 1400 700 400 301 23%
N -1680 140 840 1510 321 17%
Cash Flows (Rs.)
Project
M N
Rs. Rs.
0 560 810
5 409 520
10 276 276
15 159 70
20 53 -106
25 -40 -257
30 -125 -388
Discount rate %
NPV
Unequal expected lives (Common Time
Horizon Approach)
Particular Project A Project B
Initial outlay (Rs.) 10000 20000
Year
1 8000 8000
2 7000 9000
3 Nil 7000
4 Nil 6000
Service life (years) 2 4
Required rate of return
Cash Inflows after taxes
10%
Year Cash flow (Rs.) PV factor Total PV (Rs.)
0 -10000 1.000 -10000
1 8000 0.909 7272
2 7000 0.826 5782
3 -10000 0.826 -8260
3 8000 0.751 6008
4 7000 0.683 4781
NPV 5583
Year Cash flow (Rs.) PV factor Total PV (Rs.)
0 -20000 1.000 -20000
1 8000 0.909 7272
2 9000 0.826 7434
3 7000 0.751 5257
4 6000 0.683 4098
NPV 4061
Project A
Project B
Unequal expected lives (Equivalent
Annual Value/Cost Approach)
Project Years CFAT(Rs) PV factor (0.10) Total PV(Rs) NPV(Rs)
A 1-5 30,000 3.791 1,13,730 13,730
B 1-8 27,000 5.335 1,44,045 19,045
Project NPV(Rs) PV factor (0.10) EANPV(Rs)
A 13,730 3.791 3621.74
B 19,045 5.335 3569.82
Determination of NPV of Projects A and B
Determination of EANPV
EANPV = Net present value of the project
PV of annuity corresponding to life of the project at given cost of capital

Unequal expected lives (Equivalent
Annual Value/Cost Approach)
PV factor (0.10)
Machine A Machine B Machine A Machine B
0 (Initial Cost) 50,000 65,000 1 50,000 65,000
(Operating cost):
1-6 years (A) 6950 4.355 30267.25
1-10 years (B) 5700 6.145 35026.5
80267.25 100026.5
Less: Salvage value
6th year (A) 2000 0.564 1128
10th year (B) 5000 0.386 1930
PV of total costs 79139.25 98096.5
EAC 18172.04 15963.63
Costs (Rs) Adjusted PV(Rs)
Equivalent Annual Costs of Machines A and B
Particulars
Profitability Index
PI = PV of cash inflows
Initial cash outlay
Acceptance Rule PI
Accept PI > 1
Reject PI < 1
May accept PI = 1
Evaluation of PI method
It recognizes the time value of money
It uses all cash flows occurring over the entire life of
the project
It is a relative measure of a projects profitability
Conflict in ranking
Year Project A (Rs) Project B (Rs)
0 -50,000 -35,000
1 40,000 30,000
2 40,000 30,000
PV of cash inflow(0.10) 69,440 52,080
NPV 19,440 17,080
PI 1.3888 1.488
Capital Rationing
Project
Initial
Investment (Rs
crore) NPV ( Rs crore) PI
X 3 0.6 1.2
Y 2 0.5 1.25
Z 2.5 1.5 1.6
W 6 1.8 1.3
Project
Initial
Investment (Rs
crore)
NPV ( Rs crore) PI
Z 2.5 1.5 1.6
W 6 1.8 1.3
Y 2 0.5 1.25
X 3 0.6 1.2
Payback Period
Payback Period (Constant annual cash inflows)
Payback = Initial Investment
Annual Cash Inflow
Acceptance Rule Payback Period
Accept Payback Period < Max. payback period set
Reject Payback Period > Max. payback period set
Evaluation of Payback Period method
Simple to understand, easy to calculate and focus on
risk
Fails to take account of the cash inflows earned after
payback period
Project C
0
C
1
C
2
C
3
Payback NPV @ 10%
X -4000 0 4000 2000 2 yrs 806
Y -4000 2000 2000 0 2yrs -530
Cash Flows (Rs)
Payback Period
Fails to consider the pattern of cash flows i.e. magnitude
and timing of cash flows
Administrative difficulties may be faced in determining
the maximum acceptable payback period
Not consistent with the objective of maximizing the
market value of the firms share.
Project
C
0
C
1
C
2
C
3
Payback NPV @ 10%
X -5000 3000 2000 2000 2 yrs 881
Y -5000 2000 3000 2000 2yrs 798
Cash Flows (Rs)
Accounting Rate of Return
ARR = Average income
Average investment
Period 1 2 3 4 5 Average (Rs)
EBDIT 10000 12000 14000 16000 20000 14400
Less : Depreciation 8000 8000 8000 8000 8000 8000
EBIT 2000 4000 6000 8000 12000 6400
Taxes @ 50% 1000 2000 3000 4000 6000 3200
EBIT (1-T) 1000 2000 3000 4000 6000 3200
Book value of Investment
Beginning 40000 32000 24000 16000 8000
Ending 32000 24000 16000 8000 0
Average 36000 28000 20000 12000 4000 20000
ARR 0.16
Calculation of Accounting Rate of Return
Accounting Rate of Return
Acceptance Rule ARR
Accept ARR >Min. rate set
Reject ARR< Min. rate set
Evaluation of ARR method
It is simple to understand and use
ARR can be readily calculated from the accounting data
It incorporates the entire stream of income in
calculating the projects profitability
It uses accounting profits and not cash flows
The averaging of income ignores the time value of
money
It uses an arbitrary cut-off yardstick
Investment decisions under inflation
Discount nominal cash flows at nominal discount rate or
discount real cash flows at real discount rate.
(1+Nominal rate) = (1+Real rate)(1+inflation rate)
C
0
C
1
C
2
C
3
C
4
-10000 3000 3000 3000 3000
NPV @ 14%
NPV @ 6.54%
C
0
C
1
C
2
C
3
C
4
-10000 3210 3434.7 3675.13 3932.39
NPV @ 14% 266
Real Cash Flows (Rs)
-1258
266
Nominal Cash Flows (Rs)
Risk in Capital Budgeting
Initial Investment (Rs) 8,000 8,000 8,000 8,000 8,000
Life of the project (Years) 10 10 10 10 10
Discount Rate 15% 15% 15% 15% 15%
Operating Level (Nos) 3,000 3,000 3,000 3,000 3,000
Selling Price falls by 5% 10% 15% 20%
Selling Price (Rs) 3.2 3.04 2.88 2.72 2.56
Revenue 9,600 9,120 8,640 8,160 7,680
Variable Cost 5,400 5,400 5,400 5,400 5,400
Contribution 4,200 3,720 3,240 2,760 2,280
Fixed Costs 1,200 1,200 1,200 1,200 1,200
Depreciation 1,200 1,200 1,200 1,200 1,200
PBIT 1,800 1,320 840 360 -120
Interest ---- ---- ---- ---- ----
PBT 1,800 1,320 840 360 -120
Tax @ 40% 720 528 336 144 -48
PAT 1,080 792 504 216 -72
Cash flow from Operations 2,280 1,992 1,704 1,416 1,128
PV of Cash in flows 11,443 9,997 8,552 7,107 5,661
Net Present Value at 15% 3,443 1,997 552 -893 -2,339
% fall in NPV for 1% fall in selling price -8.40%
(Figure in Rs)
Sensitivity Analysis: Sensor Corporation
Sensitivity
Fall in NPV for 1% fall in selling price -289
Risk in Capital Budgeting
Normal
Initial cost
increases
by 10%
Cost of
capital
increases
by 10%
Variable
cost
increases
by 10%
Fixed cost
increases
by 10%
Initial Investment (Rs) 8000 8800 8000 8000 8000
Life of the project (Years) 10 10 10 10 10
Discount Rate 15% 15% 16.50% 15% 15%
Operating Level (Nos) 3000 3000 3000 3000 3000
Selling Price (Rs) 3.2 3.2 3.2 3.2 3.2
Revenue 9600 9600 9600 9600 9600
Variable Cost 5400 5400 5400 5940 5400
Contribution 4200 4200 4200 3660 4200
Fixed Costs 1200 1200 1200 1200 1320
Depreciation 1200 1320 1200 1200 1200
PBIT 1800 1680 1800 1260 1680
Interest
PBT 1800 1680 1800 1260 1680
Tax @ 40% 720 672 720 504 672
PAT 1080 1008 1080 756 1008
Cash flow from Operations 2280 2328 2280 1956 2208
Net Present Value at 15% 3443 2884 2818 1817 3082
Change in NPV for 1%change
in variable -56 -63 -163 -36
% fall in NPV for 1% fall in
selling price
-8.40%
-1.62% -1.82% -4.78% -1.05%
Sensitivity
Excellent Good Normal Bad Worst
Demand Level (no.s) 10% 5% 3000 -5% -10%
Selling Price (Rs./unit) 5% same 3.2 -5% -10%
Variable cost 10% same 5400 same 10%
Overheads 5% -5% 1200 10% 20%
Initial Investment (Rs) 8000 8000 8000 8000 8000
Life of the project (Years) 10 10 10 10 10
Discount Rate 15% 15% 15% 15% 15%
Scenario Excellent Good Normal Bad Worst
Operating Level (Nos) 3300 3150 3000 2850 2700
Selling Price (Rs) 3.36 3.00 3.20 3.04 2.88
Revenue 11088 9450 9600 8664 7776
Variable Cost 5940 5400 5400 5400 5940
Contribution 5148 4050 4200 3264 1836
Fixed Costs 1260 1140 1200 1320 1440
Depreciation 1200 1200 1200 1200 1200
PBIT 2688 1710 1800 744 -804
Interest 0 0 0 0 0
PBT 2688 1710 1800 744 -804
Tax @ 40% 1075.2 684 720 297.6 -321.6
PAT 1612.8 1026 1080 446.4 -482.4
Cash flow from Operations 2812.8 2226 2280 1646.4 717.6
Present Value of Cash in flows 14117 11172 11443 8263 3601
Net Present Value 6117 3172 3443 263 -4399
Probability (%) 15% 20% 30% 20% 15%
Expected NPV
Standard Deviaion of NPV
Coefficient of Variation
1978
1607
0.81
Scenario Analysis: Sensonr Corporation
Risk in Capital Budgeting