capital investment decisionsppt

8/7/2019 Capital Investment Decisionsppt

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Capital Investment Decisions

SY BBI


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Introduction-

The efficient allocation of capital is the most

important finance function in modern times

i.e. to commit the firms funds to the long termassets

Investment decision of a firm is generally

known as capital budgeting or capital

expenditure decision


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Definition-

A capital budgeting decision may be defined

as the firms decision to invest its current

efficiently in the long term assets in

anticipation of an expected flow of benefits

over a series of years


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Firms investment decisions generally include-

Expansion

Acquisition Modernization

Replacement of long term assets

Sale of a division or business

Change in sales distribution, aggressive

advertisement campaign, R& D programme etc.


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Features of Investment Decisions-

Exchange of current funds for future benefits

Funds are invested in long term assets

Future benefits will occur to the firm over a

series of years

Decisions by top management


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Importance of Investment decisions

They have long term implication for the firm &

can influence its risk complexion

Involve commitment of large amount of funds Irreversible decisions

Are amongst the most important decisions to

make


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Classification of investment decisions-

1. Mutually Exclusive Decisions

Ex. A company can use more labour intensive ,

semi automatic machine or employ more capital

intensive, highly automatic machine for

production

2. Independent investments- ex. A company may

increase its plant capacity to manufactureadditional units of product and may also

undertake the production of a new product.


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Contingent Investment-

Ex. A company decides to build a new plant in

remote area it may also have to invest inhouses, roads, hospitals, schools to attract the

work force.


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Investment Decision Rule

It should maximise the shareholders wealth.

It should consider all cash flows to determine the true profitability of the

project.

It should provide for an objective and unambiguous way of separating

good projects from bad projects.

It should help ranking of projects according to their true profitability.

It should recognise the fact that bigger cash flows are preferable to

smaller ones and early cash flows are preferable to later ones.

It should help to choose among mutually exclusive projects that project

which maximises the shareholders wealth.

It should be a criterion which is applicable to any conceivable investment

project independent of others.


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Capital Budgeting Process

Steps

1. Project Identification

2. Project Evaluation & Selection

3. Monitoring & Review


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Project Identification

This step is most critical & most difficult for

successful capital investment

Initial proposals can come from all levels ofmanagement

Well defined investment objective

Proper co-ordination of interrelated activities Definite duration

Projects are unique


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Monitoring & Review

After the approved project is implemented it

is monitored with the help of feedback report

Includes comparing the actual performancewith planned targets

Post completion audits


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Post Audit

An important aspect of the capital budgeting process-

(1) comparing actual results with those predicted bythe projects sponsors

(2) explaining why any differences occurred.For example, many firms require that the operating

divisions send a monthly report for the first six months

after a project goes into operation, and a quarterly report

thereafter, until the projects results are up to

expectations. From then on, reports on the operation are

reviewed on a regular basis like those of otheroperations.


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Post Audit Purpose

1. Improve forecasts.

2. Improve operations.

3. Identify termination opportunities.


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CAPITAL RATIONING

There is hardly ever enough cash to invest in allinvestment opportunities

Scarcity of resources makes one to use the

limited resources in an optimal way The act of placing restrictions on the amount of

new investments or projects undertaken by acompany. This is accomplished by imposing a

higher cost of capital for investmentconsideration or by setting a ceiling on thespecific sections of the budget.


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Example-

Suppose ABC Corp. has a cost of capital of 10%but that the company has undertaken too manyprojects, many of which are incomplete.This causes the company's actual returnon investment to drop well below the 10% level.As a result, management decides to place a capon the number of new projects by raising the costof capital for these new projects to 15%. Starting

fewer new projects would give the companymore time and resources to complete existingprojects.


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Sensitivity analysis

(SA) is the study of how the variation

(uncertainty) in the output of a mathematical

model can be apportioned, qualitatively or

quantitatively, to different sources of variation

in the input of the model . Put another way, it

is a technique for systematically changing

parameters in a model to determine theeffects of such changes.


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Evaluation Criteria

1. Discounted Cash Flow (DCF) Criteria

Net Present Value (NPV)

Internal Rate of Return (IRR)

Profitability Index (PI)

2. Non-discounted Cash Flow Criteria

Payback Period (PB)

Discounted Payback Period (DPB) Accounting Rate of Return (ARR)


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Net Present Value Method

Net present value should be found out by

subtracting present value of cash outflows

from present value of cash inflows. The

formula for the net present value can be

written as follows:

31 20

2 3

0

1

NPV

(1 ) (1 ) (1 ) (1 )

NPV(1 )

n

n

n

t

t

t

C CC CC

k k k k

CC

k!

!

!

L


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Calculating Net Present Value

Assume that Project Xcosts Rs 2,500 nowand is expected to generate year-end cashinflows of Rs 900, Rs 800, Rs 700, Rs 600and Rs 500 in years 1 through 5. Theopportunity cost of the capital may beassumed to be 10 per cent.

2 3 4 5

1, 0.10 2, 0.10 3, 0.10

4, 0.10 5, 0.

Rs 900 Rs 800 Rs 700 Rs 600 Rs 500NPV Rs 2,500

(1+0.10) (1+0.10) (1+0.10) (1+0.10) (1+0.10)

NPV [Rs 900(PVF ) + Rs 800(PVF ) + Rs 700(PVF )+ Rs 600(PVF ) + Rs 500(PVF

!

!10)] Rs 2,500

NPV [Rs 900 0.909 + Rs 800 0.826 + Rs 700 0.751 + Rs 600 0.683

+ Rs 500 0.620] Rs 2,500

NPV Rs 2,725 Rs 2,500 = + Rs 225

! v v v v

v

!


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Acceptance Rule

Accept the project when NPV is positive

NPV > 0

Reject the project when NPV is negative

NPV < 0

May accept the project when NPV is zero

NPV = 0

The NPV method can be used to selectbetween mutually exclusive projects; the one

with the higher NPV should be selected.


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Advantages

Analysis is based on the entire economic life

of the project

Recognizes time value of money Applicable for uneven cash flows

Compared projects with same initial

investments


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Disadvantages

Difficult to determine discount rate

Limited use with projects with unequal

investments

capital investment decisionsppt

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