CAPITAL

INVESTMENT
DECISION
CHAPTER 13
 INTRODUCTION
Implementing long-range plans usually
requires capital expenditures, Plans for
expansion may call for new production
facilities or new products. Since all firms have
limited capital, a manager must often choose
between several competing investments and
his skill in selecting investments ultimately
determines how well an organization performs
over the long run.
WHAT IS CAPITAL BUDGETING?
Capital budgeting is the process of deciding
whether or not to commit resources to projects
whose costs and benefits are spread over
several time periods.

1) The preparation of annual budget for

capital investment
2) the assessment of funding capacities and
3) the allocation of resources to renewal and
expansion projects which most clearly
conform with the company’s priorities .
CHARACTERISTICS OF A
CAPITAL INVESTMENT
DECISION
Capital expenditures are long-term
commitments of resources to realize future
benefits and budgeting for them is one of the
most important areas of managerial decision.
They deserve penetrating analysis and
attention of top management because of the
following reasons:
CHARACTERISTICS OF A CAPITAL INVESTMENT
DECISION

Substantial amount of Because of the length of time The effect of

funds are required in spanned by a capital managerial errors will
capital projects. investment decision, the be difficult to reverse.
element of uncertainty
becomes more critical.

Plans must be made Success or failure of the

well into an uncertain company may depend
future. upon a single or relatively
few investment decisions.
 CATEGORIES OF CAPITAL
The two general types of capital investment decisions are:
INVESTMENTS
A. Independent capital investment
projects or Screening decisions
These are projects which are evaluated
individually and reviewed against
predetermined corporate standards of
acceptability resulting in an “accept”
or “reject” decision.
B.Mutually exclusive capital investment
projects or Preference decisions.
These are projects which require
the company to choose from among
specific alternatives. The project to
be acceptable must pass the criteria
of acceptability set by the company
and be better than the other
investment alternative.
 ELEMENTS OF CAPITAL BUDGETING
THE ELEMENTS OR FACTORS TO BE CONSIDERED IN EVALUATING CAPITAL INVESTMENT PROPOSALS ARE:

1 2 3

THE MINIMUM
THE NET AMOUNT THE OPERATING ACCEPTABLE
OF THE CASH FLOWS OR RATE OF RETURN
INVESTMENT RETURNS FROM ON THE
THE INVESTMENT INVESTMENT/
COST OF
CAPITAL.
 NET INITIAL INVESTMENT OR PROJECT
COST
Net investment represents the initial cash outlay that is required to obtain future returns or the net
cash outflow to support a capital investment project. This may be computed as follows:

Initial cash outlay Pxx

ADD: Additional cash outlay related to the asset Pxx
Additional working capital _xx _xx
Total Pxx

LESS: Cash inflow arising from sale of old asset

Pxx
being replaced
Avoidable costs _xx _xx

Net Investment Pxx

____
 NET INITIAL INVESTMENT OR PROJECT
COST
The cash returns are the inflows of cash expected from a project reduced by the cash cost that can
be directly attributed to the project to the project. This computed as follows:

Annual incremental revenue from the project Pxx

Less: Incremental cash operating costs _xx
Annual cash inflow before taxes Pxx

Less:Taxes
[Tax rate(Annual cash inflow before taxes-
Depreciation)]__xx Pxx
____
Annual net cash inflow after taxes
 NET CASH RETURNS
The cash returns are the inflows of cash expected Some projects however are expected to produce an
from a project reduced by the cash cost that can be inflow of cash but will yield returns in the form of
directly attributed to the project to the project. This cash savings. The is determined as follows:
computed as follows: Annual cash operating cost(if the old asset or
Annual incremental revenue from the project method is used) Pxx
Less: Annual cash operating
Less: Incremental cash operating costs Pxx costs (if the new asset/ method is
Annual cash inflow before taxes _xx used) _xx
Annual cash savings before Pxx
Less: Taxes taxes
[Tax rate(Annual cash inflow before Pxx Less:Taxes
taxes- Depreciation)]__xx
Annual net cash inflow after taxes ____
Pxx
____

Annual cash savings after taxes ____

Pxx
____
 PROCESS OF CAPITAL BUDGETING
The capital budgeting can be divided into seven significant phases:
Finding Investment
Opportunities
Many capital expenditures
proposals can be identified
during the strategic or long-term
planning process. Since the long
term profitability of most
companies depends on the nature
and quality of their capital
investments, these investment
opportunties should be carefully
analyzed and evaluated.
Collect Relevant Information
about Opportunities
To effectively evaluate any
Investment opportunity, the
expected cash flows from
the project must be
estimated and the total cash
outlay necessary to place the
investment in operative
form must be determined.
Select Discount Rate
Before the cash flow can
be evaluated, the
discounted (cost of
capital) must be
established if the
discounted cash flow
approach is to be
applied.
 FINANCIAL ANALYSIS OF CASH
FLOWS
The techniques of capital budgeting are
applied to the estimated cash flows
developed in the second phase.
DECISION
Many, factors quantitive as well as
qualitative, should be given consideration
before the final decision is made as to the
selection of a particular investment.
PROJECT IMPLEMENTATION
Once the decision has been made to
invest funds, more detailed plans for
making the project operational are
developed.
PROJECT EVALUATION AND
APPRAISAL
This last phase involves the assessment of
how effective the investment of the actually is.
The evaluation may be in the form of
continous monitoring of the project, so that
correvtive action can be taken.
 CATEGORIES OF PROJECT CASH
FLOWS
This section of the Chapter outlines a method of estimating cash flows for investment projects. The major categories
of cash flows for a project are as follows:
CASH INFLOWS
1. Periodic cash inflows from operations, net of taxes

2. Investment tax credit

3. Proceeds from sale of old asset being replaced, net of taxes

4. Avoidable costs, net of taxes

5. Return of some working capital invested in the project*

6. Cash inflow from salvage of the new long-term asset at the end
of its useful life. This will be next of tax consequence.*
 CATEGORIES OF PROJECT CASH
FLOWS
This section of the Chapter outlines a method of estimating cash flows for investment projects. The
major categories of cash flows for a project are as follows:
CASH OUTFLOWS

7. Acquisition cost of purchasing and installing assets (e.g., new

equipment or machinery

8. Additional working capital

9.Other cash flows such as severance payments, relocation costs,

restoration costs and similar costs.

The end of a project’s life will usually result in some cash flows. These cash flows are referred to
as disinvestment flows.
 SCREENING CAPITAL INVESTMENT
PROPOSALS
Severals methods are available for the evaluation of alternative capital investment proposal. One
method may be used exclusively or combination with another. The most commonly used methods of
evaluating capital investments projects are:

A. Non-discounted cash flow B. Discounted cash flow (time-adjusted) approach

(unadjusted) approach Net Investment

1. Payback period 1. Net present value

2. Accounting rate of return 2. Discount rate of return or internal rate of
(books value rate of return) return
3. Payback reciprocal 3. Profitability index
4. Discounted payback period
 PAYBACK PERIOD
Payback period (also known as payoff and
payout period), measures the length of time
required to recover the amount of initial
investment. It is is the time interval Net Investment
between time of the initial outlay and the
Annual cash returns
full recovery of the investment. When the
period cash flows are uniform, payback
period is computed as follows:
 BAIL-OUT PERIOD

In conventional payback computations, investment

salvage value is usually is usually ignored. An approach
which incorporates the salvage value in payback
computations is the “Bail-out period”. This reached
when the cumulative cash earning plus the salvage
value at the end of a particular year equals the original
investment.
ACCOUNTING RATE OF RETURN OR SIMPLE RATE
OF TURN
Simple rate of return or Accounting rate of return (ARR) also known as book value
rate of return, measures profitability from the conventional accounting standpoint by
relating the required investment to the future annual net income. This us computed as
follows:
AAR= Average Annual Net Income
Initial Investment or Average Investment

Or, if a cost reduction project is involved, the formula becomes

AAR= Cost savings- Depreciation on new equipment

Initial Investment or Average Investment
 Decision Rule:
Under the ARR method, choose the
project with the highest rate of return.
Accept the project if the ARR is greater
than the cost of capital. Thus:
If: ARR> Required rate of return;
Accept
If: ARR< Required rate of return;
Reject
Advantages of using the ARR:
1. It is easily understood by
investors acquainted with
financial statements.
2. It is used as a rough
preliminary screening device
of investment proposals.
Disadvantages of using the ARR:
1. It ignores the time value of money by
failing to discount the future cash
inflows and outflows
2. It does not consider the timing
component of cash inflows.
3. Different averaging techniques may
yield inaccurate answers.
4. It utilizes the concepts of capital and
income primarily designed for the
purposes of financial statements
preparation and which may not be
relevant to the evaluation of
investment proposals.
NET PRESENT VALUE (NPV)
Under the discounted cash flow decision criterion, also frequently called the present-value approach, cash
outlays and cash inflows generated by the project over the amount of the initial investment. This is computed as
follows:

Present value of cash inflows computed based

on minimum desired discount rate Pxx
Less: Present value of investment xx
Net Present Value Pxx
 PAYBACK RECIPROCAL

Payback reciprocal is the reciprocal of the payback time. This often gives
a quick, accurate estimate of the internal rate of return (IRR) on an
investment when the project life is more than twice the payback period
and the cash inflows are uniform every period.
 PROFITABILITY INDEX

The Profitability Index (PI) measures the ratio between the present value of future cash
flows and the initial investment. The index is a useful tool for ranking investment projects
and showing the value created per unit of investment.
 INFLATION AND CAPITAL BUDGETING

Inflation affects the capital budgeting decision in a systematic way, even if some basic facts about
financial mathematics say it should not if one distinguishes property between nominal and real values.
The problem of the effect of inflation on the investment decision has been discussed by several authors.
This chapter discusses certain systematic effects of inflation on society and on the enterprise. The effects
of inflation on demand are related to the question about who loses and who wins in times of inflation or
rather changes in the rate of inflation.