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KNGX NOTES
ACCT2522

10. CAPITAL EXPENDITURE

10.1 NATURE AND PURPOSE OF CAPITAL EXPENDITURE DECISIONS

NATURE OF CAP EX

Capital Expenditure: a long-term decision that requires the evaluation of cash inflows and outflows over
several years to determine the acceptability of the project.

- Expenditure on resources that will generate long-term future cash flows

Cash Outflows: the initial cost of the project and any increase in costs that will be incurred as a result
of the project over its life
- Cash Inflows: cost savings and additional revenue and any proceeds of sale of assets that results from
a project

Key: value generating activities cannot be carried out if organisations do not have the resources to support
them

PURPOSE OF CAP EX

Strategy:

- Further organisation’s long-term goal for success

- E.g. enhancement of quality, expansion
- Market position

Profitability:

- Revenue generation
- Cost reduction

Regulation

10.2 CAPITAL EXPENDITURE PROCESS

Process of Investment:

1. Project generation:
2. Estimation and analysis of projected cash flows
3. Progress to approval
4. Analysis and selection of projects
5. Implementation of projects

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6. Post-implementation/completion audit of projects

10.3 INVESTMENT ANALYSIS TECHNIQUES

- Consider incremental costs and benefits

- Incremental cash outflows
o Initial cost
o Operating costs over project life
- Incremental cash inflows
o Cost savings (reduction in cash outflow)
o Additional revenues

More factors to consider

- Inflation
- Working capital
- Opportunity costs
- Disposal of equipment
- Relevant inflows/outflows after tax

More on Tax – Depreciation

- Depreciation may reduce tax

o Decrease in income tax = Depn exp * tax rate
o Reduction in cash outflow (i.e. a cash saving)
- Depreciation for tax purposes may not match depreciation for accounting purposes
- But we will assume it does!

Three main methods for Analysing Capital Expenditure Proposals

1. Payback Method
2. Accounting Rate of Return method
3. Discounted Cash Flow Analysis (NPV and IRR)

1. PAY-BACK

Payback Period: the amount of time for cash inflows from project to recover the original investment

For even cash flows

For uneven cash flow: use cumulative cash flows

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- Accept project if payback period < required time

Advantages Disadvantages
- Simple to use - It ignores the time value of money
- Screening investment projects  used as a minimum - It ignores cash flows beyond the payback
criteria screening device period
- Cash shortages  when firms are short in cash it may - Does not consider the scale of investment
be important to find projects which recoup cash quickly
- Useful for companies with liquidity issues
- Provides insight into the risk of the project

2. ACCOUNTING RATE OF RETURN

Accounting Rate of Return: the average annual profit from a project, divided by the initial investment

- Focus on incremental accounting profit that results from a project

- Also known as simple rate or return, rate of return on assets, unadjusted rate of return and return
on investment (ROI)
- Accounting rate of return:

USE OF THE AVERAGE INVESTMENT

Some managers prefer to calculate the accounting rate of return using the average amount invested in a
project for the denominator, rather than the project’s full cost. If so we use the following formula:

𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑎𝑛𝑛𝑢𝑎𝑙 𝑝𝑟𝑜𝑓𝑖𝑡 𝑓𝑟𝑜𝑚 𝑡ℎ𝑒 𝑝𝑟𝑜𝑗𝑒𝑐𝑡

𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑖𝑛𝑔 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛 =
𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

where:

(𝑖𝑛𝑖𝑡𝑖𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 + 𝑐𝑎𝑟𝑟𝑦𝑖𝑛𝑔 𝑎𝑚𝑜𝑢𝑛𝑡 𝑎𝑡 𝑒𝑛𝑑 𝑜𝑓 𝑙𝑖𝑓𝑒)

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 =
2

Advantages Disadvantages
- Can be used to screen investment projects - Does not consider the time value
- Consistency with financial accounting methods of money!!!
- Consistency with profit-based performance evaluation systems
- Considers entire life of the project
- Considers scale

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3. DISCOUNTED CASH FLOWS (NPV AND IRR)

Time Value of Money: the idea that money received today is worth more than money received in the future as
money can be invested.

Discounted Cash Flow Analysis: is a technique used in investment decisions to take account of the time value
of money.

DCF calculations involve a required rate of return

- Or discount rate, hurdle rate, weighted avg. cost of capital…

- Adjusted for risk of a project
- Minimal acceptable rate of return

Important assumptions:

- Year-end timing of cash flows

- Certainty of cash flows
- Tax is paid in the same year that the expense is incurred
- Companies are profitable i.e. not making losses
- Sales revenue = cash inflow
- Operating costs other than depreciation/amortisation = cash outflow
- Depreciation is on a straight-line basis

NET PRESENT VALUE (NPV) RULE

The Net Present Value (NPV) method calculates the present value of future cash flows of a project. Four steps
are involved:

1. Prepare a table showing the cash flows during each year of the proposed investment
2. Calculate the present value of each cash flow, using the required rate of return
3. Calculate the net present value which is the sum of the present values of the cash flows in each
period
4. Make a decision:
o If the NPV is positive, then accept
o If the NPV is negative, then reject
o The higher the NPV the more desirable the project

Compounding – Finding the future Value

FV = Future value: the value of a

FV = PV(1 + r) n PV = Present value: the initial value of an investment
r = Interest rate: expressed as decimal (R/100)
n = Period

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Discounting – Finding the Present Value

PV = Present value: the value today of the expected future cash flow
PV = FV / (1 + r)n FV = Future value: the expected value of a future cash flow
r = Interest rate: expressed as decimal (R/100)
n = Period

INTERNAL RATE OF RETURN (IRR) RULE

The internal rate of return (or time-adjusted rate of return) is the discount rate at which NPV of cash flows is
zero

1. Prepare a table showing the cash flows during each year of the proposed investment
2. Calculate the internal rate of return using a financial calculator or software program
3. Decision Rule:
o Accept project if IRR > Required Rate of Return
o Reject project if IRR < Required Rate of Return

The IRR can be calculated by solving for r in the following

Where:
p = the initial outlay
Ct = Net cash of generated by the project in period t
n = life of the project
r = the internal rate of return

NPV VERSUS IRR

Differences

- Both IRR and NPV will have the same outcome for independent projects

- But may have different outcomes for multiple or mutually exclusive project proposals
o Differences in project size/life span

 IRR: uses relative terms

 NPV: measures profitability in absolute terms
- NPV is preferred!
- BUT NPV is biased towards larger projects (smaller projects may have higher rates of returns, but
lower NPV due to smaller scale  concern if there isn’t excess capacity

Advantages of NPV


- Easier to calculate manually

- Able to adjust for risk

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- Will always yield only one answer

- Reinvestment assumption:
o IRR assumes cash flows are reinvested at the same rate as the project’s internal rate of return
o NPV assumes that cash flows are reinvested at the firm’s required rate of return

PROFITABILITY INDEX – RANKING PROPOSALS

One method that managers may use to rank investment proposals is called the profitability index (or excess
present value index)

𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤𝑠, 𝑒𝑥𝑐𝑙𝑢𝑠𝑖𝑣𝑒 𝑜𝑓 𝑖𝑛𝑖𝑡𝑖𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

𝑃𝑟𝑜𝑓𝑖𝑡𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝐼𝑛𝑑𝑒𝑥 =
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
𝑃𝑉(𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤𝑠)
=
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

LEAST-COST DECISIONS

Some managers may approve projects which have a negative NPV or a lower than acceptable IRR. These are
usually when projects are required for certain functions of the business. In these cases a “least-cost decision”
must be made.

Least-Cost Decision: a capital expenditure decision where the objective is to minimize the NPV of the costs to
be incurred.

Examples:

- Purchase of safety equipment

- Compliance with regulation
- Environmental initiatives

ACCOUNTING FOR UNCERTAINTY USING REAL-OPTIONS ANALYSIS

Real-Options Analysis: a method that explicitly recognizes uncertainties and future uncertainties and future
managerial actions taken over the life of a project

Examples:

- Asset flexibility option: the choice between two or more different forms of assets/projects
- Investment-timing option: to invest now or wait until a later date
- Growth option: the flexibility to increase (or decrease the scale of investment over the life
- Abandonment option: to cease the investment in the asset during its life

e.g. there may be a 75% chance that a competitor will enter the market

LIMITATIONS OF INVESTMENT ANALYSIS TECHNIQUES

LIMITATIONS:

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- Use of unrealistic status quo

- Hurdle rates too high (conservative discount rates)
- Time horizons too short (projects may have long term benefits)
- Difficulty in gaining approval b
- Greater uncertainty about operating cash flows (heavy reliance on estimation)
- High potential for exclusion of benefits that are difficult to quantify or put in financial terms
 Competitive concerns may be overlooked:

NON-FINANCIAL CONSEQUENCES:

- Synergistic effects of adopting multiple capital expenditure projects

- Greater flexibility in the production process
- Shorter cycle times and reduced lead times
- Reduction of non-value added costs
- Increase in business risk due to higher fixed cost structure
- Improved product delivery and service
- Benefits for the environment? Social values?

DEALING WITH LIMITATIONS:

- Try to quantify benefits (it is very hard to deny that the non-financial benefits do not exist, and
ignoring them entirely imply they have zero value, hence should at least estimate)
- Consider market conditions and economic trends
- Include strategic and competitive concerns

- Match required rate of return to uncertainty

- Conduct sensitivity analysis
o Determine how much estimates can change before an investment looks bad
- Conduct multiple scenario analysis

10.4 MANAGEMENT OF THE INVESTMENT

POST-IMPLEMENTATION & POST-COMPLETION AUDITS

Post-Completion Audit (or post-audit) is a comparison of a project’s actual cash flows with the projected
cash flows

- Serve as a control mechanism

o Which projects should be reviewed?

- Provide feedback on the accuracy of initial estimates
o Hopefully benefit future decisions and facilitate learning and to improve the practice of cash
flow predictions and capital expenditure decisions
- Two types of errors may occur
i) Undesirable projects may be accepted

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ii) Desirable projects have been rejected

- Post Completion audits can only identify the former

PERFORMANCE EVALUATION

- Performance measures
- Investment proposal generation
- Escalation of commitment