Batingal, Audrey Kim S.

Capital Expenditure - CAPEX'

Funds used by a company to acquire or upgrade physical assets such as

property, industrial buildings or equipment.
This type of outlay is made by companies to maintain or increase the scope
of their operations. These expenditures can include everything from repairing
a roof to building a brand new factory.
Are expenditures creating future benefits.
A capital expenditure is incurred when a business spends money either to
buy fixed assets or to add to the value of an existing fixed asset with a useful
life extending beyond the taxable year.

Included in capital expenditures are amounts spent on:

acquiring fixed, and in some cases, intangible assets

repairing an existing asset so as to improve its useful life
upgrading an existing asset if it results in a superior fixture
preparing an asset to be used in business
restoring property or adapting it to a new or different use
starting or acquiring a new business
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Capital Investment
Any project which a firm spends a certain amount and from which it ( the firm
) expects something in return.
Characteristics:

usually require large commitments of resources

involve long-term commitments.
more difficult to reverse than short-term decisions
involve so much risk and uncertainty
R. Roque (2011)

Commonly Used Methods and Techniques for Evaluating Capital Investments

Return on Investment (ROI)

Payback
Discounted Cash Flow (DCF)
Internal Rates of Return (IRR)
Accounting Rate of Return (ARR)
Net Present Values (NPV)

 Capital Rationing
Lease or Buy Decision
Return on Investment (ROI)
A performance measure used to evaluate the efficiency of an investment or
to compare the efficiency of a number of different investments.
Formula:
ROI = (Gain from Investment Cost of Investment) / Cost of Investment
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Payback Period
The length of time required to recover the cost of an investment.
Formula:
Payback Period = Cost of Project / Annual Cash Inflows
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ADVANTAGES:
simple to compute and easy to understand.
gives information about the projects liquidity
a good surrogate for risk. A quick payback period indicates a less risky
project.
DISADVANTAGES:
does not consider the time value of money
gives more emphasis on liquidity rather than on profitability of the project.
does not consider that salvage value of the project
ignores the cash flows that may occur after the payback period.
R. Roque (2011)
Example:
ABC International has received a proposal from a manager, asking to spend
P1,500,000 on equipment that will result in cash inflows in accordance with the
following table:
Yea
r
1
2
3
4

Net
Cash
Inflows
150,000
150,000
200,000
600,000

Cost
to
Recovered
1500,000
1350,000
1200,000
1000,000

be Payback
Years
1
1
1
1

900,000

400,000

5mos.

(400/900)*12
mos

4year & 5
mos.
Discounted Cash Flow DCF
A valuation method used to estimate the attractiveness of an investment
opportunity. Discounted cash flow (DCF) analysis uses future free cash flow
projections and discounts them (most often using the weighted average cost of
capital) to arrive at a present value, which is used to evaluate the potential for
investment.
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Formula:
Future cash flow
Present value of a future cash flow =

---------------------------

(1 + Discount rate)n
Example:
ABC Company is planning to acquire an asset that it expects will yield
positive cash flows for the next five years. Its cost of capital is 10%, which it uses as
the discount rate to construct the net present value of the project. The following
table shows the calculation:
Year
0
1
2
3
4
5

Cash Flow 10% Discount Factor

Present Value
-$500,000 1.0000
-$500,000
+130,000
0.9091
+118,183
+130,000
0.8265
+107,445
+130,000
0.7513
+97,669
+130,000
0.6830
+88,790
+130,000
0.6209
+80,717
Net Present Value
-$7,196

The net present value of the proposed project is negative at the 10% discount
rate, so ABC should not invest in the project.
Internal Rates of Return
A measure for evaluating whether to proceed with a project or investment.
Is sometimes referred to as :
economic rate of return (ERR).

 Time-adjusted Rate of Return

Discounted Cash Flow Rate of Return (DCFRR)

Decision criteria:
If the IRR is greater than the cost of capital, accept the project.

If the IRR is less than the cost of capital, reject the project.

These criteria guarantee that the firm will earn at least its required return.
Such an outcome should increase the market value of the firm and, therefore, the
wealth of its owners.
ADVANTAGES:
emphasize cash flows
recognizes the time value of money
computes the true return of the project
DISADVANTAGES:
assumes that the IRR is the re-investment rate
when project includes negative earnings during their economic life, different
rates of return may result
When cash inflows are uniform , the IRR can be determined by:
1. Computing the factor of IRR
Formula: Factor of IRR = Investment / Net Cash Inflows
2. On line n (number of periods) of the annuity table, find the factor for the IRR
obtained in Step 1. The corresponding i is the IRR.
R. Roque (2011)
Accounting Rate of Return (ARR)
Also called:
Book Value Rate of Return,
Financial Accounting Rate of Return
Average Return on Investment and
Formula:
ARR = Accounting Net Income / Initial Investment
ADVANTAGES:
ARR computation closely parallels
measurement and investment return.

accounting

concepts

of

income

facilitates re-evaluation of projects due to the ready availability of data from

the accounting records.
method considers income over the entire life of the project.
indicates the project's profitability

DISADVANTAGES:
does not consider time value of money
With the computation of income and book value based on the historical cost
accounting data, the effect of inflation is ignored.
R. Roque (2011)

Example:
For new equipment acquisitions, Jhun Corporation set a payback goal of 3
years and desired rate of return of 25% based on initial investment. An equipment
to be used in Jhun Corporations Forming Department is being evaluated. Data
pertaining to the equipment are as follows:
Cost
of
the P1,800,0
Equipment
00
Useful Life
10 years
Salvage Value
0
Jhun Corporation is subject to 40% income tax rate. It uses he straight line
methodin computing depreciation.
Solution:
Recquired annual net cash Inflow
(1800,000 / 3 yrs)
Less : Depreciation (1800,000 / 10 yrs)
Recquired Net Income

ARR

P600,0
00
180,00
0
420,00
0

= Accounting Net Income / Initial Investment

= 420,000 / 1,800,000
= 23.33%

The expected accounting rate of return based on initial investment on the

new equipment is 23.33%, lower than the desired rate of return of 25%. Therefore,
project is not acceptable because expected rate of return is lower than the desired
rate of return.

Net Present Values (NPV)

The difference between the present value of cash inflows and the present
value of cash outflows. NPV is used in capital budgeting to analyze the profitability
of an investment or project.
www.investopedia.com

Formula:
PV of Cash
Inflow
-PV of Cash
Outflow
Net Present
Value

PV of Cash Inflow
-PV of Cost of
Investment
Net Present Value
PV of Cash
Inflow
-Cost of
Investment
Net Present
Value
ADVANTAGES:
emphasizes cash flows
recognizes the time value of money
assumes discount rate as the reinvestment rate
easy to apply
DISADVANTAGES:
requires pre-determination of the cost of capital or the discount rate to be
used
the net present values of different competing projects may not be
comparable because of differences in magnitudes or sizes of the projects.
Example:
J-ro Corporation is planning to buy a new equipment costing P600,000. The
equipment will be depreciated using the straight line method over a period of 5
years. It is expected to have a salvage value of P10,000 at the end of its life.

The equipment will produce annual cash flows from operations, net of income
taxes, of P180,000 per year. The income tax rate is 32%, The companys hurdle rate
is 12%. What is the NPV?
PV of cash inflows
From operations (180,000 x P648,9
3.605)
00
Salvage Value (10,000 x . 5,670
567)
Total PV of Cash Inflows
654,
570
Less Cost of Investment
600,00
0
NPV
P54,5
70
Capital Rationing
Capital rationing is a process through which a limited capital budget is
allocated between different projects in a way that maximizes the shareholder's
wealth.
-termsexplained.com

Example:
Black Gold Exploration is an oil and gas exploration company operating in
northwestern Qamadan. It has secured four exploration licenses from the
government for Block C,L and Y. Black Gold Exploration has total budget of $8
billion. Block C, L and Y are expected to generate total value (present value of cash
flows) of $5 billion, $6 billion and $4 billion respectively while the respective initial
investment required for each is $3 billion, $4 billion and $3 billion. Find the optimal
product mix.
In order to maximize shareholders' wealth, the company has to accept projects
that maximize total value added. For this, it needs to rank the projects in the
descending order of their profitability indices and accept projects with higher
profitability indices till there are no enough funds available for next project.

Block C's profitability index = $5 billion/$3 million = 1.67

Block L's profitability index = $6 billion/$4 billion = 1.5
Block Y's profitability index = $4 billion/$3 billion = 1.33
Since the total budget is $8 billion, BGE can invest only in Block C and L. It
will have to surrender Block Y. Although Block Y has positive net present value, the
company does not have any funds to invest in the block.

Lease or Buy Decision

is a decision based on the results of a cost/benefit analysis of the costs to
own, costs to lease, and the and disadvantages of any relevant qualitative factors.

Present Value When comparing leasing and purchasing alternatives, the

future monetary value you would expend in a lease or lease-purchase
contract must be converted to its value in present monetary value in order to
compare the real costs of each option. Calculating Present Value can be used
as an intermediate step to calculating Net Present Value (NPV)

Net Present Value When comparing cost of leasing and purchasing

alternatives, it may be necessary to calculate the total costs and benefits
over the entire life of a project. Net present value analysis involves four basic
steps.

1.
2.
3.
4.

The
The
The
The

first step is to forecast the benefits and costs in each year

second step is to determine a discount rate
third step is to use a formula to calculate the net present value
final step is to compare the net present values of the alternatives
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