CAPITAL INVESTMENT DECISION

Capital investment decisions are those decisions that involve current outlays in return for a stream of benefits in the future years. They are long term decision taken. They are those decisions where a significant period of time elapses between the outlay and the recoupment of the investment. Capital investment decisions normally represent the most important decisions that an organization makes, since they commit a substantial proportion of a firms resources to actions that are likely to be irreversible. Such decisions are applicable to all sectors of society. Business firms investment decisions include investments in plant and machinery, research and development, advertising and warehouse facilities. Investment decisions in the public sector include new roads, schools and airports. Individuals investment decisions include house-buying and the purchase of consumer durables.

INVESTMENT APPRAISAL METHODS PAYBACK METHOD The payback method is one of the simplest and most frequently used methods of capital investment appraisal. It is defined as the length of time that is required for a stream of cash proceeds from an investment to recover the original cash outlay required by the investment. Under this criterion a business should invest its money in the project with the shortest payback period. Example A firm wishes to invest its 50,000.00 in either project A or project B. project A has the following cash infows:

Years 1 2 3 4 5 6 7

A 10,000 20,000 20,000 20,000 10,000 5,000 5,000

B 10,000 10,000 10,000 20,000 30,000 30,000 30,000

Advice the Firm which Project should they embark on. Two obvious deficiencies are apparent from these calculations. First, the payback method does not take account cash flows that are earned after the payback date and, secondly, it fails to take into account the differences in the timing of the proceeds which are earned before the payback date. Despite the theoretical limitations of the payback method it is the method most widely used in practice. It is a particularly useful approach for ranking projects where a firm faces liquidity constraints and requires a fast repayment of investments. The payback method may also be appropriate in situations where risky investments are made in uncertain markets that are subject to fast design and product changes or where future cash flows are extremely difficult to predict. The payback method assumes that risk is time-related: the longer the period, the greater the chance of failure. By concentrating on the early cash flows, payback uses data in which managers have greater confidence. A further attraction of payback is that it is easily understood by all levels of management and provides an important summary measure: how quickly will the project recover its initial outlay?

ACCOUNTING RATE OF RETURN The accounting rate of returns (also known as the return on investment and return on capital employed) is calculated by dividing the average annual profits from a project into the average investment cost. It differs from other methods in that profits rather than cash flows are used. Example The directors of A Ltd are contemplating the purchase of a new machine to replace a machine which has been used for the last five years. Ignoring interest but considering tax at 50% of net earnings, suggest which of the two alternatives should be preferred: Old machine Purchase price Estimated life of machine Machine running hrs per annum Units per hour Wages per hour ($) Power per annum Consumable stores per annum Other charges per annum Material cost per unit ($) Selling price per unit ($) 40,000 10 years 2,000 24 3 2,000 6,000 8,000 0.50 1.25 New machine 60,000 10 years 2,000 36 5.25 4,500 7,500 9,000 0.50 1.25

You may assume the above information regarding sales and cost of sales will hold good throughout the economic life of each of the machines. Depreciation has to be charged according to straight line method.

Solution Profitability statement Old machine Cost of machine Life of machine Output (units) $40,000 10 years 48,000 New machine $60,000 10 years 72,000

Sales value Less cost of sales: Direct materials Wages Power Consumables stores Other charges Depreciation Profit before tax Tax at 50% Profit after tax 24,000 6,000 2,000 6,000 8,000 4,000

60,000

90,000

36,000 10,500 4,500 7,500 9,000 50,000 10,000 5,000 5,000 6,000 73,500 16,500 8,250 8,250

Net Earnings AV. Investment

*100

5000 20,000 = 25%

*100

8,250 *100 30,000 = 27.50%

Thus replacement of the old machine by the new machine is preferable.

THE CONCEPT OF NET PRESENT VALUE By using discounted cash flow techniques and calculating present values, we can compare the return on an investment in capital projects with an alternative equal risk investment. The most straightforward way of determining whether a project yields a return in excess of the alternative equal risk investment in traded securities is to calculate the net present value (NPV). This is the present value of the net cash inflows less the projects initial investment outlay. If the rate of return from the project is greater than the return from an equivalent risk investment in securities traded in the financial market, the NPV will be positive. Alternatively, if the rate of return is lower, the NPV will be negative. A positive NPV therefore indicates that an investment should be accepted, while a negative value indicates that it should be rejected. A zero NPV calculation indicates that the firm should be indifferent to whether the project is accepted or rejected. Example The MBA company is evaluating a project with an expected life of four years and an investment outlay of $1 million. The estimated net cash inflows for the project are as follows: Year 1 300,000, Year 2 1,000,000, Year 3 400,000 and year 4 500,000

The project has 200,000 sale value at the end year four. The is a depreciation of 100,000 each year. The company will introduce an additional working capital of

200,000 in year three. These had been excluded from the calculation of the cash inflows. The opportunity cost of capital is 10%. You are require to calculate the NPV of this project.

THE INTERNAL RATE OF RETURN The IRR is an alternative technique for use in making capital investment decisions that also take into account the time value of money. The IRR represent the true interest rate earned on an investment over the course of its economic life. The IRR is the interest rate K that when used to discount all cash flows resulting from an investment, will equate the present value of the cash receipts to the present value of the cash outlays. In other words, it is the discount rate that will cause the net present value of an investment to be zero. Alternatively, the internal rate of return can be described as the maximum cost of capital that can be applied to finance a project without causing harm to the shareholders. The IRR can be found by trial and error by using a number of discount factors until NPV equals zero. The decision rule is that if the IRR is greater than the opportunity cost of capital, the investment is profitable and will yield a positive NPV. Alternatively, if the IRR is less than the cost of capital, the investment is unprofitable and will result in a negative NPV. The interpolation method can be used to calculate the IRR without carrying out trial and error calculations. The formula using the interpolation method is as follows: A+ C C-D Where A is the discount rate of the low trail, B is the discount rate of the high trial, C is the NPV of cash inflow of the low trial and D is the NPV of cash inflow of the high trial.
6

(B-A)

PROFITABILITY INDEX The profitability index is the third method of evaluating capital investment proposal that takes into account the time value of money. The method is simply a variation of the NPV method, and it is computed by dividing the present value of the cash proceeds by the initial cost of investment. If the profitability index is less than 1, the investment should be rejected. If it is greater than 1, the investment should be accepted. This method is consistent with the NPV method, since the index can only be less than 1 when the NPV is negative. Similarly, an index greater than 1 only arises when the NPV is positive.

CAPITAL RATIONING It has been suggested that all investments with positive net present values should be undertaken. For mutually exclusive projects the project with the highest NPV should be chosen. However, situations may occur where there are insufficient funds available to enable a firm to undertake all those projects that yield a positive NPV. The situation is described as capital rationing. Capital rationing occurs whenever there is a budget ceiling, or a market constraint on the amount of funds that can be invested during a specific period of time. The term soft capital rationing is often used to refer to situations where, for various reasons the firm internally imposes a budget ceiling on the amount of capital expenditure. On the other hand, where the amount of capital investment is restricted because of external constraints such as inability to obtain funds from the financial markets, the term hard capital rationing is used.

Whenever capital rationing exists, management should allocate the limited available capital in a way that maximizes the NPVs of the firm. Thus it is necessary to rank all investment opportunities so that the NPV can be maximized from the use of the available funds. Example A division of the MBA company that operates under the constraint of capital rationing has identified seven independent investments from which to choose. The company has $20 million available for capital investment during the current period. Which projects should the company choose? Projects investment Required($m) A B C D E F G 2.5 10.0 5.0 10.0 12.5 2.5 5.0 Present Value($m) 3.25 10.825 7.575 12.35 13.35 3.0 5.9