Chapter 01 Capital Expenditure Decision

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1 Learning Objectives : Capital Expenditure Decisions To Develop an analytical understanding of capital budgeting To Expound the process involved in the evaluation of capex projects. Structure: Introduction Nature & Significance Capital Budgeting Technique An Overview Classification of Investment Projects Evaluation of Investment Opportunities Capital Budgeting Technique Classification of Investment Project Evaluation of Investment Opportunities Investment in Working Capital

2 Introduction In the first part of Financial Management, we e learnt a lot about capital expenditure & revenue expenditure, difference between the two, their treatment etc. In this chapter, we are going to see the other side of coin. This chapter attempts to develop an analytical understanding of capital budgeting as a technique of capital expenditure decision & the process involved in the evaluation of capital expenditure projects.

3 Nature Every organisation has to invest in capital first, then try & earn profit. Investment in capital is very important decision as this investment is irreversible and its benefits are to be reaped over a long time span. The capital expenditure [capex] decision acquisition of new facilities as well as replacement of machinery & equipment. Advertising campaigns or research & development expenses of large size & duration also qualify as capex. By nature, capital expenditure can be classified into two categories i) Screening Decision : Reviewing capex proposals against acceptance standards. ii) Preference Decision: Choosing the most beneficial among several competing proposals screened & accepted.

4 Significance The capital expenditure decision is a single most important financial decision because a) Slight error & it affects the financial health of organisation for a long period of time. b) Investment is one time but, the benefits are to be reaped over number of accounting years. c) It cannot be reversed easily as reversal costs are enormous. d) The investment has to be arranged in such a way that it does not put any strains on current financial operations of the company.

5 Capital Budgeting Technique In view of overwhelming importance of capital expenditure decision, modern management uses capital budgeting technique that provides precise means to choose the most useful project for the enterprise. It matches marginal revenue generated by the project with its marginal cost. Marginal revenue is represented by the rate of return on investment & marginal cost by company s marginal cost of capital.

6 Capital Budgeting Technique Capital budgeting is an evaluation technique, which involves three basic steps, 1. Classification of investment proposal into certain category for ease of analysis. 2. Measuring benefits & cost of each of these proposals. 3. Finally, ranking of proposals in order of their desirability. These steps constitute profitability analysis of investment proposals. While profitability analysis is most important, other factors like social responsibility, environment, have to be considered for final decision. We discuss first two steps in this chapter, while the third step is detailed in the next chapter.

7 Classification of Investment Project The investment proposals in an enterprise can be classified into four types according to the way benefits from the investment are affected by or affect other possible investments. 1. Mutually exclusive investment proposals 2. Independent investment proposals 3. Contingent investment proposals 4. Replacement investment proposals

8 Evaluation of Investment Opportunities After proper classification of prospective capital investments, the next step is their evaluation. As a matter of fact, evaluation of opportunities implies comparison of net investment outlay of the project with net cash earnings. This point will be more clear with this chart. Investment Opportunities Opportunities in Terms of Cash Flows Evaluation of Cash Flows in Their Time Value

9 Evaluation of Investment Opportunities Investment Opportunities Opportunities in Terms of Cash Flows Net Investment Outlay Net Cash Benefits After Taxes

10 Evaluation of Investment Opportunities Evaluation of Cash Flows in their Time Value Theory of Interest Computation of Present Value of Present Values Series of Cash Flows Simple Compound F 1 = P ( 1 + r) F n = P ( 1 + r)n. where F 1 the amount to be received in one year, P = the present outlay to be made, r = the rate of interest involved, n = years,

11 Evaluation of Investment Opportunities Evaluation of Cash Flows in their Time Value Theory of Computation of Interest Present Values Present Value of Series of Cash Flows Simple Compound F 1 = P ( 1 + r) F n = P ( 1 + r)n. where F 1 the amount to be received in one year, P = the present outlay to be made, r = the rate of interest involved, n = years,

12 Evaluation of Investment Opportunities Evaluation of Cash Flows in their Time Value Theory of Computation of Present Value of Interest Present Values Series of Cash Flows Simple Compound F 1 = P ( 1 + r) F n = P ( 1 + r)n. where F 1 the amount to be received in one year, P = the present outlay to be made, r = the rate of interest involved, n = years,

13 Investment in Working Capital The decision in investment in a capital project has to be supported by an investment in working capital; such as accounts receivables & inventory. If capital investment is to replace machinery which offers 25% more production, we have to procure 25% more raw material over what was required for the old machine. Increased sales resulting from new machine need support for higher receivables. Such investment in working capital in the form of current assets is usually recovered in full at the end of capital project s useful life. So one must consider such working capital additions in capital budgeting decisions.

14 IN SHORT From all above discussion, it is quite clear that the decision of capital expenditure is very crucial & requires special type of attention, calculation of after tax cash inflows & outflows, minute consideration of all the relevant facts & figures including increased working capital required to support capital investment. It is finance manager s task to derive perfect combination of expenditure with that of expected income after taking into account all above factors. If net cash inflows are significant, the capex can be recommended for implementation.

15 the end! next chapter two investment decision methods. Good luck!