Capital Expenditure

Decisions

Sem1
Prof Rajasree, IBS Kochi MBA, MS, CFA
FM 1
 Capital Expenditure Decision

 Also called capital budgeting.

 A decision which involves company’s fund to be invested

efficiently in long term projects/ assets in anticipation of an

expected flow of benefits over a series of years.

 The project generally runs for long periods.

 Involves huge amount of investment.

 These decisions are irreversible in nature.

 Steps in Capital Budgeting

 Sources for project/ product idea

 Preliminary screening

 Feasibility Study

 Project Implementation

 Review
 Sources for product ideas
Market characteristics of different Industries: if there exists a demand

supply mismatch. E.g. Maggi noodles

Imports and Exports: Government is keen on promoting export oriented

and import substitution ind., hence potential investment opportunities can

be found if imports and exports are studied.

Emerging Technologies: analyzing the commercial viability of new

technologies can provide opportunities. E.g. Xerox

Backward and Forward Integration: own outputs can be used to make

products. E.g. Deepak Fertilizers manufacturing ammonia based fertilizer.

 Preliminary Screening
• The list of prospective investment opportunities are now subject to

screening.

 Compatibility with promoter

 Compatibility with Governmental Priorities

 Availability of Raw material and utilities

 Size of potential market

 Cost

 Risk of the project

 Feasibility Study
 Once the project opportunity is chosen and it is considered acceptable

after the preliminary screening, a feasibility study is to be conducted.

 Market & Demand, Technical, Financial Projections, Project Valuation,

Economic, Social Cost Benefit and Risk Analysis aspects are looked

into and a Detailed Project Report (DPR) is prepared.

 Fairly detailed estimates of project cost, means of financing, estimates

of cost and benefit streams in terms of cash flows, estimates of

profitability, debt servicing capability, & social profitability is

conducted.
 Implementation and Review
• Stages of Implementation:

– Negotiating for finances from various sources

– Construction of building; Installation of machinery etc.

– Training of engineers, technicians, workers etc

– Commissioning of plant and trial run

– Commercial production

Performance Review
 Project Appraisal
Market & Demand Appraisal: total market and market share of the project

Technical Appraisal: technical aspects like project design, quality and

quantity of raw materials, scale of operations etc

Financial Projections: project cash flow projections

Project Valuation: Valuing the viability of a project

Economic Appraisal: impact of project on social life of people around,

employment, distribution of income in society, pollution etc.

Social Cost Benefit analysis: keeping in mind the national objectives

Risk analysis: the study of the inherent risks in the project

 Financial appraisal

• Basic 2 steps involved:

– Define stream of cash flows (inflows and outflows) associated.

– Appraise the cash flow stream to determine whether the project is

financially viable

Assumptions –

 Cash flows occur only once in a year

 Risk of the project is same as that of other projects of the firm.

 Calculating the CASH FLOWS
• All costs and benefits are measured in terms of CASH FLOWS.

Hence all non cash expenses (depreciation) has to be added

back to PAT in order to calculate operating Cash flow.

• Interest on Long Term Loans are not deducted in calculation of

PAT. It is because the WACC used includes post tax cost of long
term funds. Hence if Interest on LT funds are considered it will
be double counting.

• But interest on ST funds like Working capital and short term

bank finance are considered.

 Example
Following are the extracts of a project in Company A:

Assets required lakh Project is financed by lakh

Land 80 Equity Share capital 500

Building 100 12% Pref. Share capital 250

Plant & Machinery 500 16% Term Loan 300

Other FA 100 18% Bank Loan for WC 340

Technical Know how 160

Gross WC 450
 Example Continued
The company is expected to generate sales value of Rs 10 crore in 1st,
12 crore in 2nd and 15 crore in next 3 years. Cost of production
excluding depreciation would be 70% of sales. The rate of depreciation
on building is 4% on SL method and 331/3 % WDV method on P&M and
other FA. Tech. know how fees are written off over a period of 5 years.
Salvage value of P&M after 5 years would be 20% of acquisition cost,
nil for other FA & book value for L&B. Term Loan for project will be
repaid after 5 years when the project is sold. Tax rate is 30% and COC
is 20%.
 To judge the viability of a project
Payback period

 Non – Discounting Accounting rate of return

 Discounting NPV

Benefit Cost Ratio

Internal Rate of Return

Annual Capital Charge

 Example 2
• Following data is available for two projects A and B.
Years Cash Outflows (lakh) Cash Inflows (lakh)
Project A Project B Project A Project B
1 9 10 10 15
2 7 15 15 25
3 2 20 12 40
4 3 8 10 50
5 1 -- 9 --

Project A has life of 5 years and B has a life of 4 years. Initial

investment in A and B are 5 lakh and 12 lakh respectively.

Calculate: 1. NPV; 2. IRR; 3. Payback period;

4. BCR; 5. NBCR and 6. ACC