Capital Expenditure Decisions What is capital expenditure, what are
Chapter 12 – Capital Expenditure Decisions What is capital expenditure, what are the 4 steps of a capital expenditure decisions? -‐ capital expenditure decision -‐ long-‐term decision where business determines whether or not to make an investment at the time in order to obtain future net cash receipts that’ll exceed the investment (positive ROI) -‐ 3 categories of investment alternatives: new investments (increase revenue); new technology (save costs); replacement of old assets as they wear out -‐ risks of investment: involve large amounts of resources, uncertainty, difficult to reverse, span over long periods of time -‐ general rule: capital expenditure proposal is acceptable when return on investment is greater than cost of providing the cash to make the investment -‐ Steps in making a capital expenditure decision: What does a business include in the initial cost of a capital expenditure proposal? Estimating the initial cash payment -‐ initial cost-‐expected cash payment to be made to put proposal into operation -‐ sometimes, the proposal requires investment of additional working capital -‐ initial costs may involve the use of estimates (e.g. quotes from contractors) Estimating future cash flows -‐ expected future net cash receipts help to provide ROI -‐ 3 forms of net future cash receipts: 1) future cash receipts only (e.g. no future outflows-‐dividends) 2) future cash receipts exceed future cash payments, positive net cash inflow 3) savings of future cash payments, reduction in future cash outflow (no cash inflow) (e.g. upgrading to more fuel efficient and saving fuel costs in future) What are the relevant costs of a capital expenditure proposal and how do operating income, depreciation and ending cash flows affect these costs? -‐ relevant cash flows: future cash flows that differ in amount or in timing as a result of accepting a capital expenditure proposal; relevant as it affects business’ long-‐term profitability -‐ relevant cash flows are: the expected additional future cash flows; expected savings in future payments -‐ deciding which cash flows are relevant for the decision is similar to deciding what costs are relevant for a short-‐term decision -‐ to be relevant to a particular capital expenditure decision, cash flows must: o occur in the future o result from activities that are required by the proposal o cause a change in the business’ existing cash flows Operating income, depreciation and ending cash flows -‐ most revenues & expenses result in cash in & outflows approx. at same time -‐ expected future operating revenues&expenses are frequently used as estimates for relevant future cash inflows and outflows -‐ depreciation expenses are not cash flows -‐ but acquisition cost(of investment) is a cash outflow and the scrap amount (if any) is a future cash inflow
How does a business determine the rate of return it requires on a capital expenditure proposal? Determining the required return on investment -‐ required return=cost of providing cash for investment (expressed as %) -‐ business’ financial position improves if accepting capital expenditure proposal provides a return that’s higher than cost of the investment -‐ cost of capital-‐rate that measures cost of providing cash for investment -‐ capital comes from interest, dividends, etc. each source demands ROI -‐ cost of capital is the weighted-‐average cost it must pay to sources of capital -‐ cost of capital is the cut-‐off rate used to distinguish between acceptable&unacceptable capital expenditure proposals; to be acceptable: return on proposal must be equal/greater than business’ cost of capital -‐ consistent cost of capital rate must be used for evaluating proposals Determining acceptable capital expenditure proposals -‐ business may use different methods to analyse whether a capital expenditure proposal is acceptable (e.g: NPV method; payback method; accg rate of return method) Time value of money and present value (ACST) -‐ time-‐value of money –$1 in the future is worth less than $1 now -‐ FV=PV(1+i)n (e.g. FV=100 (1+0.04)1 = $104) !"# -‐ To find present value: rearrange future value formula; PV = (!.!")! = $100 -‐ -‐ -‐
Present value=today’s value of $ amount received in the future Use 1st table for compound (single payment) Use 2nd table for annuity (multiple payments)
How does a business use the net present value method to evaluate a capital expenditure proposal? -‐ NPV considers the time value of money and involves a 3-‐steps process: 1) determine initial (present time) cash payment needed to implement proposal 2) determine present value of expected future net cash receipts from proposal 3) determine NPV by subtracting amount in Step 1 from amount in step 2 -‐ note that NPV is net outcome; if NPV is zero/positive, proposal is acceptable as it’ll earn at least the required rate of return -‐ adv of NPV: expected cash flows & timing are considered, decision rule is explicit -‐ disadv: relies on discount rate, actual return in terms of % investment outlay isn’t revealed What is the difference between the payback method and the accg rate of return on investment method for evaluating a capital expenditure proposal? -‐ this evaluates a capital expenditure proposal based on the payback period -‐ payback period-‐length of time required for a return of initial investment -‐ decision: accept project with shortest payback period -‐ example: payback period is 3.009 yrs (100/11000=0.009) -‐ adv of payback method: simple to calculate, easy to understand, incorporates awareness of risk in decisions
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disadv: ignores time value of money & cash inflow after payback, too simple to be used as a decision support tool by itself Accounting rate of return method (ARR) !"#$!%# !""#!$ !"# !"#! !"#$ !"#$ !""#$!!""#!$ !"#$"%&'(&)* !" !""#$ -‐ ARR= (!"#$%& !"#$%&!" !" !""#$ !"! !"!#!$% !"#$!!"#$%&'( !"#$%)/! -‐
Average annual net cash flow from asset = !"# !" !"#! !"#$ !"! !"#! !"#"$%&'!!"#$%&'( !".!" !"#$ !"#$%&'
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Annual depreciation on asset =
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Useful in comparing several different projects as ARR can be ranked but it ignores time value of money ARR should be used in support of the NPV method Decision: project with highest ARR (which is also higher than required return and also has positive NPV) is usually chosen Adv of ARR: simple to calculate, easy to understand, consistent with return on assets (ROA) measure Disadv: time value of money is ignored, importance of cash is ignored, profits and costs maybe measured in different ways
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!"!#!$% !"#$!!"#$%&'( !".!" !"#$ !"#$%&'
How does a business decide which capital expenditure proposal to accept when it has several proposals that accomplish the same thing, or when it cannot obtain sufficient cash to make all of its desired investments? Mutually exclusive capital expenditure proposals -‐ refers to proposals that accomplish the same thing, so that when 1 proposal is selected, the others are not (e.g. considering buying aircon) -‐ Step 1: analyse each proposal to determine whether or not it’s acceptable -‐ Step 2: select one of the acceptable alternatives by choosing proposal with highest positive NPV Capital Rationing -‐ occurs when business cannot obtain sufficient cash to make all investments that it would like to make -‐ business chooses combo of capital expenditure proposals that provides the highest total NPV for the total investment available Practical Issues 1) collecting data: costs, revenues and cash flows may not be easy to determine 2) opportunity costs: cost of foregoing benefits of other alternative proposals 3) risk: data may be inaccurate; changes may occur in the future 4) finance: some investments seem good but obtaining loans may be difficult 5) human resources: will there be employees/consultants available with required skills available required by the project? 6) Social responsibility and care of the natural environ: can affect business decisions (e.g. pollution), social and environ costs may be hard to estimate
How does a business determine the rate of return it requires on a capital expenditure proposal? Determining the required return on investment -‐ required return=cost of providing cash for investment (expressed as %) -‐ business’ financial position improves if accepting capital expenditure proposal provides a return that’s higher than cost of the investment -‐ cost of capital-‐rate that measures cost of providing cash for investment -‐ capital comes from interest, dividends, etc. each source demands ROI -‐ cost of capital is the weighted-‐average cost it must pay to sources of capital -‐ cost of capital is the cut-‐off rate used to distinguish between acceptable&unacceptable capital expenditure proposals; to be acceptable: return on proposal must be equal/greater than business’ cost of capital -‐ consistent cost of capital rate must be used for evaluating proposals Determining acceptable capital expenditure proposals -‐ business may use different methods to analyse whether a capital expenditure proposal is acceptable (e.g: NPV method; payback method; accg rate of return method) Time value of money and present value (ACST) -‐ time-‐value of money –$1 in the future is worth less than $1 now -‐ FV=PV(1+i)n (e.g. FV=100 (1+0.04)1 = $104) !"# -‐ To find present value: rearrange future value formula; PV = (!.!")! = $100 -‐ -‐ -‐
Present value=today’s value of $ amount received in the future Use 1st table for compound (single payment) Use 2nd table for annuity (multiple payments)
How does a business use the net present value method to evaluate a capital expenditure proposal? -‐ NPV considers the time value of money and involves a 3-‐steps process: 1) determine initial (present time) cash payment needed to implement proposal 2) determine present value of expected future net cash receipts from proposal 3) determine NPV by subtracting amount in Step 1 from amount in step 2 -‐ note that NPV is net outcome; if NPV is zero/positive, proposal is acceptable as it’ll earn at least the required rate of return -‐ adv of NPV: expected cash flows & timing are considered, decision rule is explicit -‐ disadv: relies on discount rate, actual return in terms of % investment outlay isn’t revealed What is the difference between the payback method and the accg rate of return on investment method for evaluating a capital expenditure proposal? -‐ this evaluates a capital expenditure proposal based on the payback period -‐ payback period-‐length of time required for a return of initial investment -‐ decision: accept project with shortest payback period -‐ example: payback period is 3.009 yrs (100/11000=0.009) -‐ adv of payback method: simple to calculate, easy to understand, incorporates awareness of risk in decisions
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disadv: ignores time value of money & cash inflow after payback, too simple to be used as a decision support tool by itself Accounting rate of return method (ARR) !"#$!%# !""#!$ !"# !"#! !"#$ !"#$ !""#$!!""#!$ !"#$"%&'(&)* !" !""#$ -‐ ARR= (!"#$%& !"#$%&!" !" !""#$ !"! !"!#!$% !"#$!!"#$%&'( !"#$%)/! -‐
Average annual net cash flow from asset = !"# !" !"#! !"#$ !"! !"#! !"#"$%&'!!"#$%&'( !".!" !"#$ !"#$%&'
-‐
Annual depreciation on asset =
-‐
Useful in comparing several different projects as ARR can be ranked but it ignores time value of money ARR should be used in support of the NPV method Decision: project with highest ARR (which is also higher than required return and also has positive NPV) is usually chosen Adv of ARR: simple to calculate, easy to understand, consistent with return on assets (ROA) measure Disadv: time value of money is ignored, importance of cash is ignored, profits and costs maybe measured in different ways
-‐ -‐ -‐ -‐
!"!#!$% !"#$!!"#$%&'( !".!" !"#$ !"#$%&'
How does a business decide which capital expenditure proposal to accept when it has several proposals that accomplish the same thing, or when it cannot obtain sufficient cash to make all of its desired investments? Mutually exclusive capital expenditure proposals -‐ refers to proposals that accomplish the same thing, so that when 1 proposal is selected, the others are not (e.g. considering buying aircon) -‐ Step 1: analyse each proposal to determine whether or not it’s acceptable -‐ Step 2: select one of the acceptable alternatives by choosing proposal with highest positive NPV Capital Rationing -‐ occurs when business cannot obtain sufficient cash to make all investments that it would like to make -‐ business chooses combo of capital expenditure proposals that provides the highest total NPV for the total investment available Practical Issues 1) collecting data: costs, revenues and cash flows may not be easy to determine 2) opportunity costs: cost of foregoing benefits of other alternative proposals 3) risk: data may be inaccurate; changes may occur in the future 4) finance: some investments seem good but obtaining loans may be difficult 5) human resources: will there be employees/consultants available with required skills available required by the project? 6) Social responsibility and care of the natural environ: can affect business decisions (e.g. pollution), social and environ costs may be hard to estimate
