Introduction

 Decisions regarding acquisition of fixed assets

and other long-term projects of the company are
critical to the future profitability and success of the
company.
 Such investment includes purchase of equipment,
acquisition of land and buildings, introduction of
new products and so on.
 Introduction
 The importance of capital investments also lie in the fact
that large sums of money are normally sunk into these
investments and once decisions on them are made, they
are nearly always irretrievable.
 Whereas the returns on these investments go into the
future and may be highly uncertain in some cases, the
expenditure on them is now.
 Introduction
 The future cash flows have to be properly estimated and
this is the most difficult aspect of the planning and
evaluation process.
 Having estimated the future cash flows of each capital
investment available, will evaluate each investment
proposal using the appropriate appraisal techniques.
 Each investment proposal should be assessed on the
basis of its ability to achieve the minimum expected
return by the providers of t he funds that will be
channeled to that proposal.
Capital Expenditures
 Refer to substantial outlay of funds the purpose of
which is to lower costs and increase net income for
several years in the future. It includes expenditures
that tie up capital inflexibility for long periods. It
covers not only outlays for fixed assets but also
expenditures for major research on new products
and methods and for advertising that has
cumulative effects
Classes of Capital Expenditures
 Replacement investments
 Expansion investments
 Product line or new market investments
 Investments in safety and/or environmental projects
 Strategic investments
 Other investments
Capital Expenditure Planning and Control

 Capital Expenditure planning and control is a process

of facilitating decisions covering expenditure on long-
term assets.
 Capital Expenditures – include all expenditures on
tangible and in some cases intangible assets which are
expected to produce benefits to the firm over a
period of time (not less than one year.)
 Capital Expenditure Planning and Control is an
integral part of the corporate plan of an organization
Capital Expenditure Planning and Control

 The Capital Budgeting process includes:

a. Identification
b. Development
c. Evaluation
d. Authorization
e. Control
Identification of investment opportunities
 Identification of investment proposals is the most critical
aspect of the investment process and should be guided
by the overall strategic considerations of a firm.
 Once the investment proposal has been identified, each
potential idea should be developed into a project and
submitted for appraisal to determine its viability and
worthiness.
Identification of investment opportunities
 A sound appraisal technique which should maximize
the shareholder’s wealth should be used to measure
the economic worth of the projects.
 In this respect, there would be a need to consider
all cash flows, to determine the true profitability of
the project. This will involve the development of cash
flow estimates.
Developing Cash Flow Estimation
 Estimation of cash flow is a difficult task because the
future is uncertain. Therefore, the risk associated with
cash flow should be handled properly and taken into
account in the decision process as the estimation of
cash flow requires collection and analysis of all
quantitative and qualitative data.
Evaluation of the Net Benefits
 In selecting a method or methods of investment
evaluation, a company should take adequate care to
ensure that the criteria selected would lead, to the net
increase in the company’s wealth, that is, its benefit
exceeds its cost adjusted for time value and risk.
 The evaluation criteria should also not discriminate
between investment proposals.
 Whatever criterion that is applied, it should be
capable of ranking projects correctly in terms of
profitability.
Evaluation of the Net Benefits
 In this particular case, the net present value method
(NPV) is theoretically recommended, among others by
experts as it has a true measure of profitability. It
ranks projects correctly and is consistent with the
wealth maximization criterion.
 However, other methods in use apart from the NPV
are the payback period, the internal rate of return
(IRR), accounting rate of return (ARR) and profitability
index (PI).
Evaluation of the Net Benefits
 In the implementation of a sophisticated evaluation system, the use
of a minimum required rate of return is necessary. This should be
based on the riskiness of cash flows of the investment proposal
which are considered to be normally influenced by the following
factors:
a. Price of raw materials and other inputs;
b. Price of products (selling price);
c. Product demand;
d. Government policies;
e. Technological changes;
f. Project life; and
g. Inflation
Evaluation of Proposed Capital Expenditures

 Urgency
 Repairs
 Credit
 Non-Economic Factors
 Investment worth
 Risk involved
Authorization to Spend
 There is no specific standard administration procedure
for approving investment proposal as it differs from
one company to another.
 When large sums of capital expenditure is involved,
the authority for the final approval may rest with the
Board or the top management which may be the Chief
Executive of the company.
 The approval authority may be delegated to the
junior management for certain types of investment
project involving small amounts.
Authorization to Spend
 Funds are usually appropriated for capital
expenditure from the capital budget after the final
selection of investment proposals.
 Top management are to ensure that funds are spent in
accordance with appropriations made in the capital
budget.
 Funds for the purpose of project implementation
should be spent only after approval has been granted
by the finance manager or any other authorized
person.
Control and Monitoring of Capital Projects

 A capital project reporting system is required to

review and monitor the performance of investment
projects during and after completion.
 This will mean comparing the actual performance with
original estimates. It will require regular reporting
either monthly, quarterly or semi-annually.
 The evaluation reports may among others include
information on expenditure to date, stage of physical
completion and approved and revised total cost.
Control and Monitoring of Capital Projects

 The reappraisal may also include consideration of the

comparison between actual and forecast capital cost
savings and rate of return. The perceived advantages
of reappraisal are:
a. Improvement in profitability by positioning the project as
per the original plan;
b. Ascertaining of errors in investment planning which can
be avoided in the future;
c. Guidance for future evaluation of projects; and
d. Generation of cost consciousness among the project
team.
Investment Appraisal Techniques
 Investment decisions affect the value of the firm and this
will increase, if investments are profitable and add to
shareholder’s wealth.
 It is, therefore important to ensure that investments are
evaluated on the basis of criteria which are compatible
with the objective of the shareholder’s wealth
maximization.
 It is necessary to examine the different methods of
selecting investment in long-term assets, that is, capital
expenditure, to be able to determine the most valid
technique of evaluating an investment project.
Investment Appraisal Techniques
 A number of capital budgeting techniques are used in
practice. They are grouped into two major categories:
1. Discounted Cash Flow (DCF) Techniques
a. Net Present Value (NPV)
b. Internal Rate of Return (IRR)
c. Profitability index (PI); and
d. Discounted payback period
2. Non- Discounted Cash Flow Techniques
Investment Appraisal Techniques
 It is important to emphasize that expenditure on and
benefits of an investment should be measured in cash.
In this respect, it is the cash flow that is important and
not the accounting profit.
 However, it is assumed that the capital projects
opportunity cost of capital (rate of return) is known.
 It is also assumed that the expenditure and benefits
of the investment are known with certainty.
Investment Appraisal Techniques
1. Non- Discounted Cash Flow Techniques
a. Payback Period (PB); and
b. Accounting Rate of Return (ARR)
 In evaluating an investment, three steps are involved:
a. Estimation of cash flows;
b. Estimation of the required rate of return (cost of
capital);
c. Application of a decision rule for making the choice
Non-Discounted Cash Flow Techniques

 Payback period technique

 This technique shows the number of years over which the
investment would be recovered.
 It is the period usually expressed in years, in which the
cash outflows will equate the cash inflows from a project.
 This technique measures projects on the basis of the period
over which the investment pays back itself or the period
of recovery of the initial investment.
 The full recovery of the projects cash outflow would be
measured through the cash inflows.
Payback Period Technique
 This method pays attention to the shortness of the project, that is,
the shorter the period of recovery of initial investment or capital
outlay, the more acceptable the project becomes.
 Where there is constant or uniform annual net cash flows from a
project, the payback period is calculated thus:

 Payback Period = Initial Investment (Capital Outlay)

Annual Net Cash Flow
Payback Period Technique
 Decision rule
 If the payback period is calculated for a project is less
than the maximum or standard payback period set by
management, it would be accepted, if not, it would be
rejected.
 If the firm has to choose among two mutually exclusive
projects the project with shorter payback period will be
selected.
Payback Period Technique
 Advantages of Payback Method
a. It is simple to calculate and better understood of all the
methods of capital budgeting.
b. It least exposes the firm to the problem of uncertainty
since it focuses on shortness of project to pay back the
initial outlay.
c. It is a fast screening technique especially for the firms
that have liquidity problems.
Payback Period Technique
 Disadvantages of Payback Method
a. It does not take account of the cash inflows earned after
the payback period.
b. It does not take into account the time value of money
c. It does not take into account the risks associated with
each project and the attitude of the company to risk.
Accounting Rate of Return
 The accounting rate of return (ARR) technique is
derived from the concept of return on capital
employed (ROCE) which is also known as return on
investment (ROI).
 It uses accounting information provided by the
financial statements to measure the profitability of an
investment. It is calculated by dividing the average
after-tax-profit by the average book value of the
investment during its life.
Accounting Rate of Return
 ARR = Average Income____ x 100%
Average Investment
 Decision Rule:
 The rule is to invest in all projects whose accounting rate
of return (ARR) are higher than the company’s pre-
determined minimum acceptable rate
 Where mutually exclusive projects are concerned, the
rule is to accept the project with the highest ARR
Accounting Rate of Return
 Advantages of Accounting Rate of Return
 It is easy to calculate
 It is simple to understand and use

 It incorporates the entire stream of income in calculating

the project’s profitability.
 Accounting Rate of Return
 Disadvantages of Accounting Rate of Return
 It uses accounting profits in appraising the projects.
 The averaging of income ignores the time value of money.
 It uses an arbitrary cut off yardstick
 It is an average concept and as such will hide the sizes and timing of
the individual cash flows.
 It does not take into consideration the risk associated with each project
as well as the attitude of the management to risk.
 There is no unique definition for ARR. For instance “average profit” may
be profits after depreciation, interest and tax. Initial investment could
be initial investment plus scrap value or just initial investment.
Discounted Cash Flow (DFC) Techniques

 Net Present Value (NPV) Method

 is one of the discounted cash flow techniques that
recognizes the time value of money
 It is the net contribution of a project to its owners wealth,

 It is the present value of future cash flows minus the

present value of the initial capital investment.
 All cash flows are discounted to their present values using
the required rate of return.
Net Present Value (NPV) Method
 The formula for calculating NPV are as follows
Net Present Value (NPV) Method
 Advantages of NPV
a. It recognizes the time value of money’
b. It uses all cash flows occurring over the entire life of the
project;
c. It measures in absolute terms (Peso/Dollar value) the
increase in wealth of the shareholders; and
d. It facilitates measuring of cash flows in terms of present
values. This implies that if the values of separate assets
are known, the firms value can simply be found by
adding their values. This is called the value-additivity
principle.
Net Present Value (NPV) Method
 Disadvantages of NPV
a. It is more difficult to calculate than the payback and the
accounting rate of return; and
b. It relies heavily on the correct estimation of the cost of
capital, that is, where errors occur in the cost of capital
used for discounting, the decision would be misleading.
Internal Rate of Return (IRR)
 The internal rate of return method is another
discounted cash flow technique which takes account
of the time value of money.
 It is also known as yield of a project, marginal
efficiency capital, rate of return over cost, time
adjusted rate of return and so on.
 It is defined as the cost of capital for which the NPV
of a project would be zero.
Internal Rate of Return (IRR)
 It is a break-even point cost of capital. It is also the
cost of capital or discount rate that will equate the
cash inflows of a project with the cash outflows of
that project.
 The formula for calculating the IRR is:
Internal Rate of Return (IRR)
 The formula shows that it is the same as that for
calculating NPV.
 The only difference is that in NPV method, the
required rate of return is assumed to be known while
in IRR method the required rate of return has to be
determined, hence, the result is equated to zero.
 Internal Rate of Return (IRR)
 An alternative method to the above formula is the trial
and-error method. This is also know as interpolation
method.
 In this method, the discounting factor yielding a positive
NPV is improved to move towards negative and a midway
is discovered to arrive at zero. The formula:
 Internal Rate of Return (IRR)
 Decision rule:
 Accept all projects whose IRR are greater than the
company’s cost of capital.
i.e. Accept if r > k
Reject if R < k
May accept or reject if r = K
Where r = internal rate of return and k = cost of capital
If mutually exclusive projects are being considered the rule is to
accept the project that produces the highest IRR.
 Internal Rate of Return (IRR)
 Advantages of IRR
a. It recognizes the time value of money
b. It considers all cash flows occurring over the entire life of
the project
c. It gives the same acceptance rule as the NPV method
d. It is consistent with the stakeholders wealth maximization
objective.
 Internal Rate of Return (IRR)
 Disadvantages of IRR
a. It is more difficult to calculate than the other methods.
b. It can give misleading and inconsistent results when the
NPV of a project does not decline with discount rates.
c. In some cases, it fails to indicate a correct choice between
mutually exclusive projects.
d. Unlike in the case of NPV, the additivity principle does not
hold when IRR method is used – IRR projects do not add
e. Sometimes, it yields multiple rates.
 Profitability Index (PI) Technique
 The profitability index (PI) method is another cash flow
technique.
 It is the ratio of the present value of cash inflows, at the
required rate of investment. It may be gross or net that is,
gross minus one.

1+
Profitability Index (PI) Technique
 Decision rule
 Accept all projects whose PI is greater than 1 (one)

i.e. Accept if PI > 1

Reject if PI < 1
Profitability Index (PI) Technique
 Advantages of PI
a. It recognizes the time value of money
b. It is a variation of the NPV method and requires the
same computation as in the NPV method
c. It is a relative measure of a project’s profitability since
the present value of cash inflows is divided by the initial
cash outflow.
d. It is generally consisted with the wealth maximization
principle
Profitability Index (PI) Technique
 Disadvantages of PI
a. It can only be used to choose projects under simple,
one period, capital constraint situations.
b. It does not work when mutually exclusive projects or
dependent projects are being considered.
Discounted Payback Period Technique
(DPPT)
 This technique is an improvement over the payback
method.
 It is aimed at overcoming the problem of the time
value of money disadvantage of the normal
payback method, by incorporating into its
calculation, the discount factor.
 In the discounted payback period method, the cash
flows are discounted and used in the calculation of
the payback period.
Discounted Payback Period Technique
(DPPT)
 Advantages of Discounted Payback Period
Technique
a. It recognizes the time value of money
b. It focuses on shortness of project to payback the initial
outlay
c. In addition to the fact that it recognizes the time value
of money it has all the advantages of the payback
method.
Discounted Payback Period Technique
(DPPT)
 Disadvantages of Discounted Payback Period
Technique
a. It does not take into account the cash inflows earned
after the payback period.
b. It does not take into account the risks associated with
each project and the attitude of the company to risk
c. Except that it uses discounted cash flows, it has all the
disadvantages of payback method.