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CHARACTERISTICS OF CAPITAL

INVESTMENT DECISIONS

Significant cash outlay;Long term involvement with greater risks

and uncertainty because forecasts of the

future are less reliable;

Irreversibility of some projects due to

their specialized nature, e.g., plant whichhaving been bought with a specific project

in mind may have little or no scrap value;

1



significant time lag between commitment of

resources and the receipt of cash benefits;

!anagement"s ability is often stretched withsome projects, demanding an awareness of all

relevant diverse factors;

Limited resources re#uire priorities on capitale$penditure;

%roject completion time re#uires ade#uate

continuous control information as costs can be

e$ceeded by a significant amount.

10/19/15 By Felix O Boateng 2



FACTORS TO CONSIDER INUNDERTAKING CAPITAL APPRAISAL

i. Initial cost of the project;ii. &he phasing of the e$penditure;

iii. 'stimated life of the investment;iv. mount and timing of resulting

net cash inflows from the project;




v. &he effect, if any, on the rest of the

undertaking;

vi. 'stimated residual value of the project

at the end of its life, if applicable;

vii. (ost of capital;viii. )orking capital re#uirements, if any;

i$. &a$ation implications of the project;$. Inflation rates and the effect on the

project.




The capital investmentappraisal process

Capital investment appraisal is offundamental importance because:

1.It will involve the commitment ofa large amount of companyresources which necessitates

careful evaluation to beundertaken before a decision isreached.




2.Investment decisions areusually linked to strategicand tactical businessdecisions and therefore

need to achieve desiredlong-term objectives i.e.

ma!imisation ofshareholder wealth".




#. It can be e!tremely e!pensive anddi$cult to reverse an investment

decision% so care needs to bee!ercised in reaching the initialinvestment decision.

&. 'rojected future bene(ts and costsare di$cult to predict.Conse)uently% the risk and

uncertainty of undertaking amedium to long-term investmentcan be high.




The decision-makingprocess1. Initial investigation *efore the proposal is subject

to detailed evaluation% it isuseful to undertake preliminaryinvestigation to determine ifthe proposal appears to be afeasible project.




+his initial investigation willconsider such factors as% theresources re)uired% thetechnical and commercial

feasibility% the risks of theproject% and how the project

matches the (rm,s strategicobjectives.




2. Detailed evaluation If a project appears to be

feasible% a detailedinvestigation of all facets will beundertaken. +his include:attempting to forecast thee!pected cash ows from the

project% and possibly calculationof the '/% I00 or otherrelevant techni)ues.




+he '/ method of appraisalshould be used wherever

possible% as it is consistent withthe objective of shareholderwealth ma!imisation.

+he results of this analysis

should be compared with theresults of any other optionsavailable.10/19/15 By Felix O Boateng 11



ensitivity analysis may beapplied to the results in orderto help assess the degree ofrisk involved in the project.

In addition to the (nancialanalysis% sources of (nance for

the project and non-(nancialfactors will need to be detailed.




3. Authorisation

In the case of largeinvestment projects% thedecision to accept a particular

proposal should be made bysenior management% orperhaps the board of directors

if necessary.




+he decision-making body mustbe satis(ed that the proposal

meets the necessary proftabilitycriteria and is compatible withthe overall strategy o the

business. here there areinsu$cient funds to undertake allthe proposals put forward% rankingof proposals in order of priority willneed to be employed.




4. Project implementation 3nce the decision to proceed

has been taken% the appointmentof a project manager or theassignment o responsibility

for the project will be necessary. +he person given theresponsibility will need to beallocated the re)uired resourcesand to be given speci(ed targetsto achieve.




5. Monitoring the project

3nce the project is underway% senior

managers should be kept informedof progress on a regular basis.

6. Postcompletion audit

3nce the project has beenimplemented% a post-completionaudit should be conducted in order

to monitor and report on projectprogress as well as to identifyaspects which could be improved for

future project planning.10/19/15 By Felix O Boateng 16



!valuation methods +he availability of funds is likely to be

limited% conse)uently organisationsmay not be able to undertake allavailable% feasible projects.

+herefore% comprehensive analysis isre)uired so that alternatives can beassessed% choices made and projectsprioritised.

Investment in a capital project can onlybe justi(ed if the additional bene(tse!ceed the costs of the investment.




+here are four major methods of evaluatinginvestment proposals:

1.4ccounting rate of return 400"2.'ayback period ''"#.et present value '/" method

&.Internal rate of return I00".5 +he (rst two methods are the

traditional methods of appraising

investments and have been aroundfor many years.5 +he '/ method is a more recent

development.10/19/15 By Felix O Boateng 18



+his method discounts thefuture cash ows associated

with the investment projectusing cost o capital to theentity, as the appropriate

discount rate. +he decision rule is that if the

net present value of thediscounted cash ows ispositive% we should accept the

project.10/19/15 By Felix O Boateng 19



It is important to be aware ofthe advantages of this method

over the 400 and '' methods. +he most importantadvantages of the '/ method

are that it:1. takes account of the time value

of money% by discounting thecash ows arising in the future.




2. It takes account of all relevantcash ows%

#. provides a clear decision ruleconcerning acceptance6rejection

of a project

&. is consistent with the objectiveof ma!imising shareholderwealth% which is assumed to bethe primary objective of a

business.10/19/15 By Felix O Boateng 21



+he Internal 0ate 0eturn I00" +his method is the last

method listed above and issimilar to the '/ method.

It is based on the principle ofdiscounting future cash owsand will normally give the

same accept6reject decisionsand will rank investmentprojects in the same way asthe '/ method.


7 h I00 h d h



7owever% the I00 method hasdi$culty in handling unconventionalcash ows and does not address the

issue of wealth ma!imisation as wellas the '/ method. +hus% from atheoretical viewpoint% the I00 methodis inferior to the '/ method.7owever% it seems that managersprefer the I00 method to the '/method. +his is perhaps because it

provides an answer that is e!pressedas a percentage (gure% which iseasier to understand than presentvalue


i l i i



ome practical issues ininvestment appraisal:

Relevant costs3nly future costs that varywith the decision should beincluded in the analysis. +hismeans that past costs and

committed costs should beignored because they cannotvary with future decisions

concerning the investment.10/19/15 By Felix O Boateng 24

O i



Opportunity costs3pportunity costs do not

result in cash movements.evertheless% they should be

taken into account as theyrepresent real "ene#ts$oregone.


T ti



TaxationInvestors are concerned with the

after-ta! bene(ts from theirinvestment. +his means that%where ta!ation information is

provided in a )uestion% it must betaken into account. +he a$ter

ta% cash &o's from aninvestment should be discountedusing the a$terta% cost o$

capital.10/19/15 By Felix O Boateng 26

C



Cash fows

In '/ analysis% it is cash ows

rather than pro(t ows that areused because it is the former thatgives a business command overresources. In some caseshowever% a )uestion may provide

information concerning futurepro(ts rather than future cashows.


h thi it i



hen this occurs% it isnecessary to convert the pro(t

ows into cash ows% whichcan be done by adding "ac(an) noncash items appearing in the pro(t andloss account. +he most

common e!ample of a non-cash item is depreciation.


W ki it l



Working capitalhere pro(t ows are

converted into cash ows%some adjustment may be

necessary in respect of theinvestment in workingcapital over the period of theproject.


4 dditi t ki



4ny addition to workingcapital will be treated as a

cash outow and any releaseof working capital will betreated as a cash inow in theperiod in which it occurs.


I t t t



Interest payments

Interest payments are not

deducted in arriving at therelevant cash ows for theinvestment project.

+he cost of (nancing is taken intoaccount in the discount ratewhich is based on the cost of

capital" and so should not betaken into account again whenderiving the relevant cash ows.




Ta e!!ect on investmentappraisalhen considering the ta! implications

the following procedure is followed:1.forecast the incremental cash owe!cluding ta!ation over the life of theproject8

2.determine the (rst year allowance 94"and writing down allowances ;4s"over the life of the project and estimate

the disposal proceeds of the investmentat the end of its useful life8

#.determine the balancing allowance or

balancing charge810/19/15 By Felix O Boateng 32

& < t th # t d



&. o<set the #rst )ear and'riting do'n allo'ances

from the incremental cash&o's and compute the ta%

pa)a"le or repa)a"le* and=. consider the timing of the ta!

payable or repayable andadjust the incremental cashows.


!%ample



!%ample

4 company wishes to select a project froma choice of two mutually e!clusive options.

Option A: +his option will generate a singlecash inow of >7c=?%??? in three years,time.

Option B: +his option will generate cashinows of >7c1&%@?? per annum after one%two and three years.0e)uired:

Compare the '/ of two options when costof capital is:

i" 1?A per annum8 and

ii" 12A per annum.10/19/15 By Felix O Boateng 34

olution



olution

i" 4t 1?A cost of capital:

Option A

4t 1?A the present value is>7c=?%??? ! ?.B=1 >7c#B%==?

Option B4t 1?A the present value is>7c1&%@?? ! 2.&DE >7c#B%?&1


+ote, +he present value of 3ption



+ote, +he present value of 3ption* has been calculated by using thecumulative present value annuity"factors. +his time saving techni)ue can beemployed when cash ows are thesame amount for a number ofperiods. +o ensure you understandthe use of cumulative present valuetables% it may be worth checking theaccuracy by calculating the presentvalue of each year and totalling the

present values as follows:10/19/15 By Felix O Boateng 36



ear Cash ow 1?A ;. factors'resent value >7c

1 1&%@?? ! ?.@?@ 1#%=&&2 1&%@?? ! ?.D2E 12%#?B

# 1&%@?? ! ?.B=1 11%1@?

#B%?&1

It is worth noting that for 3ption *% usingthe cumulative present value factor or the

present value factors% the net presentvalue is the same in total i.e.%>7c#B%?&1". +he cumulative present valuefactor is ?.@?@ F ?.D2E F ?.B=1 2.&DE.


In conclusion on the basis of



In conclusion% on the basis of(nancial analysis% at a cost of

capital of 1?A 3ption 4 is preferredas its present value is higher by>7c=?@ >7c#B%==? G >7c#B%?&1".

ii" 4t 12A cost of capital

Option A 4t 12A the present value is>7c=?%??? ! ?.B12 >7c#=%E??


Option B



Option B

4t 12A the present value is

>7c1&%@?? ! 2.&?2 >7c#=%B@?In conclusion% on the basis of

(nancial analysis% at a cost ofcapital of 12A 3ption * ispreferred as its present value is

higher by >7c1@? >7c#=%B@? G>7c#=%E??".


H!ample



H!ample

Calculate the present value of the followingseries of cash ows if the cost of capital is 12A.

4n immediate cash outow of >7c1?%???. 4tthe end of each of the ne!t three years cashinows of >7c2%=?? p.a.% thereafter at the endof each of the subse)uent three years>7c1%=?? p.a.

ear Cash ow 12A ;. factors 'resentvalue

? 1?%???" 1.??? 1?%???"1 G # 2%=?? 2.&?2 E%??=

& G E 1%=?? 1.B1? 2%=E=

'/ 1%&#?"10/19/15 By Felix O Boateng 40

In conclusion the project is not



In conclusion the project is not(nancially viable% as it results in a

negative present value.+ote,

+he cash ows are the same forthe end of each of the (rst threeyears% conse)uently the cumulative

three year12A factor can be used.i.e.: ?.D@# F ?.B@B F ?.B12 2.&?2"


+he cash ows are the same for



+he cash ows are the same forthe end of each of the

subse)uent three years years &to E"% again the cumulativepresent value factors can be

used to calculate the presentvalue of the cash ows for years

& to E inclusive.i.e.: ?.E#E F ?.=EB F ?.=?B 1.B1".


NPV: Illustrative Question 2



NPV: Illustrative Question 2&wo mutually e$clusive projects, * and +, have the

following estimated cash flows in hana (edis over its life

span of - years.

ear ! 2 " # $

%roject * -, -, /, 0, 0,

%roject + 0, 1, 2, -, 3,

Re%uire&:

If the initial capital outlay is 4c00,- and the cost of

capital is 05, calculate the 6%7 of %rojects * and +. dvise

management if they should undertake any of the projects.


Su''este& Solution to (Illustrative Question 2



Su''este& Solution to (Illustrative Question 2

%roject * 8iscount %roject + 8iscount9ear (ash :low :actor %7 (ash flow :actor %7

4c 4c 4c 4c0 -, . /,-/- 0, . 1 -, .<13 /,02 1, .<13 0,3-12 /, .=-0 2,/ 2, .=-0 1,1-2/ 0, .3<2 3<2 -, .3<2 2,/0-- 0, .310 310 3, .310 2,=13

%resent 7alue of Inflows > 01,<2 00,--%resent 7alue of ?utflows > @00,-A > @00,-A

6et %resent 7alue 0,/<2 /--

De)ision: %rojects * and + both have positive 6%7s, but since the twoare mutually e$clusive and both cannot be e$ecuted, managementshould go in for %roject * which has a higher positive 6%7.

44

INTERNAL RATE OF RET*RN +IRR,



INTERNAL RATE OF RET*RN +IRR,

?ften an entity would want to establish its

internal rate of a project for various reasons e.g.,for decisionBmaking purposes. Cy I++, we mean

a rate that will be used to discount future cash

inflows to make the total of the present valuese#ual the cost of the project.

&he attempt made under I++ is ti find a rate that

will e#uate the 6%7 of a project to be zero.




&he I++ therefore is the ma$imum rateof discount that will be used to finance a

project without making a loss from it.In a mutually e$clusive situation, the project that has the highest I++ is the

one to recommend, the reason being thatthe I++ is showing the highest rate thatcan be used to finance a project without

incurring a loss from it.&he I++ can be referred to as the breakB

even rate.46

Illustrative Question



Illustrative Question

Senior management of ?ffshore

'$ploration @hanaA Limited haveidentified that there is a strategic need for

a replacement machine to be ac#uired in

one of their production departments. &heyhave to make a choice between two

models of the machine D !odel 0 @SuperA

and !odel 1 @8e Lu$eA.




&hey are unsure as to which of the

two models they should buy.

&hey have given you the following

profiles of the two models. &hey wantyou to use the two investment

appraisal techni#ues, 6%7 and I++.


9 i d d



9ou are re#uired to recommend

which of the two models is better

under each appraisal techni#ue and to

e$plain briefly why you have

recommended one in place of theother under each techni#ue.

9ou are told that funds are onlyavailable for only one model.


S -er Del e



Su-er Delu.e

Cost /H)$001000 /H)001000

Net Cash inflow GHc GHc

9ear 0 1-, 0-,

1 0, 1,

2 0, 1-,

/ -, 0,

- 0-, 0,

3 0, 1-,

Scrap value 1, <,

50

&h t f it l i 015 @N t



&he cost of capital is 015. @Note:

8iscount factors readable from

financial tablesA





Solution1 usin' NPV te)3ni%ue: Dis)ount rate 4!25



Su-er Mo&el Delu.e Mo&el

9ear (ash Dis) %7 (ash %7

:lows 6a)tors values :lows values

@-,A !7000 @-,A @<,A @<,A

0 1-, 078" 122,1- 0-, 022,-

1 0, 07989 =,= 1, 0-,/

2 0, 079!2 =0,1 1-, 0=<,

/ -, 07" 20,< 0, 32,3

- 0-, 07$9 <-,- 0, -3,=

3 0, 07$09 3,</ 1-, 03=,20

E 1, FFFFFF E <, FFFFFF T3ere6ore NPVs 4 $!1#0 @/0,/A

Re)o;;en&ation: *n&er t3e NPV ;et3o& Su-er 3as a -ositive NPV o6 /H)$!1#0

<3ilst De Lu.e 3as a ne'ative NPV o6 /H)#!10#07 Su-er Mo&el is t3ere6ore

re)o;;en&e& to ;ana'e;ent7

53

*sin' IRR te)3ni%ue:



' %

Su-er Mo&el1 using G8iscount rate of say, 15 , to enable

us obtain a negative 6%7 so we can apply the I++

formulaHear Cas3 Flo< PV 6a)tors PV value

@-,A 0. -,

0 1-, .<22 1<,1-

1 0, .3/ 3,/

2 0, .-= -=,

/ -, ./<1 1/,0

- 0-, ./1 3,23 0, .22- /,1

= 1, FFFFFF

NPV 4 +"81$0,

54

A--l>in' t3e IRR 6or;ula1



-- > ' 1

IRR 4 A = + a ? +a = @, . + B A,

)hereH

> Lower discount rate that gives positive 6%7

C > 4igher discount rate that gives negative

6%7 a > 7alue of positive 6%7

b > 7alue of negative 6%7

I++ > 01 E @-0,</@-0,</ E 2<-A $ @1 D 01A

> 01 E /.-1

IRR 6or Su-er ;o&el 4 !7$25

55

IRR 6or Delu.e ;o&el using 8iscount rate of say /5 to obtain a



IRR 6or Delu.e ;o&el, using 8iscount rate of say, /5, to obtain a

positive 6%7.

9ear (ash :low 8isc factors %7 values

@<,A 0. @<,A0 0-, .31 0//,2

1 1, .1- 0<-,

2 1-, .<< 111,1-

/ 0, .<-- <-,-- 0, .<11 <1,1

3 1-, E <, .= 13,=

NPV 4 !9818$0

&herefore I++ > / E 0=,-@0=,- E /0,/A $ @01 D /A

> / E 3.-0

IRR 6or Delu.e Mo&el 4 !07$!5

56



Re)o;;en&ation:

&he 8eLu$e !odel has an I++

of 0.-05. s this is lower than

the Super !odel"s 03.-15, thelatter will be recommended.

57

DISCOUNTED CAS" FLO#S UNDER INFLATION



Inflation may be defined as a general increase

in prices, leading to a general decline in the

real value of money.

&here will be two impacts of inflation on 8(:

project appraisal as followsH

&he discount rate given may include an

allowance for a general rate of inflation.

&he cash flows may be subject to inflation, possibly at different rates for different cash

flows.


E66e)t o6 in6lation on t3e &is)ount rate



E66e)t o6 in6lation on t3e &is)ount rate

&he discount rate used in investment

appraisal reflects the finance provider"sre#uired rate of return @e.g. the rate of

interest on a loan raised, or shareholders"

re#uired return if financed by e#uityA.In times of inflation, the fund providers will

re#uire a return made up of two elementsH

return to compensate for inflation @to

maintain purchasing powerA


real return on top of this for the use of



real return on top of this for the use of

their funds.

&he re#uired return that incorporates bothof these elements is known as a money

return.


Illustrative Question !



Illustrative Question !

n investor is prepared to invest

4c0 for one year. 4e re#uires a

real return of 05, in addition to an

allowance for inflation, currentlyrunning at -5.

Re%uire&: )hat is the investor"s;one> rate o6 returnJ


Solution



Solution

&o compensate for inflation, his money

needs to increase by -5, which is 4c0$ 0.- > 4c0-

&o give a return on top of this, it must

further increase by 05, to 4c0- $ 0.0

> /H)!!$7$

4ence the investor"s money must increaseoverall by 0.- $ 0.0 > 0.--, i.e. by !$7$57


T3ere6ore1 t3e investors ;one> rate



T3ere6ore1 t3e investor s ;one> rate

o6 return 4 !$7$5

In)lu&in' in6lation in DCF a--raisals8(: analysis can take place in either

money or real terms, as long as the twoare not confused.

+eal rates of return are obtained, using

the following e#uationH




0 E m > @0 E rA @0 E iA

)hereH m > money discount rate

r > real discount rate, and i > inflation rate


Illustrative Question 2



project has the following cash flows before

allowing for inflationH

9ear (ash flow @4cA

@=-A

0 22 1 1/1

2 -21

&he money discount rate is 0-.-5. &he general

rate of inflation is e$pected to remain constant at

-5.10/19/15 By Felix O Boateng 65

Re%uire&: Value t3e -roe)t in ter;s o6:



@aA +eal cash flows and discount rates

@bA!oney cash flows and discount rates.

Solution

(a) Real cash flows and discount rates

8iscount rate, 0-.-5, as per the

#uestion includes investor"slender"sinflation e$pectation of -5.




4ence real discount rate, r, is given

by 0 E r > @0 E mA@0 E iA

0 E r > @0 E .0--A@0 E .-A 0 E r > 0.0

T3ere6ore r 4 !05


9ear (ash :low %7 factor %resent value



4c 4c

@=-A 0. @=-A

0 22 . 2

1 1/1 .<13 1

2 -21 .=-0 / NPV !$0


@bA Money cash flows and discount



@bA Money cash flows and discount

rates

&he discount rate, 0-.-5, as per

the #uestion is the money discount

rate. (ash flows, however, need to be increased by -- compound each

year , to allow for inflation.


Year Real cash Inflation Money Discount Present



flow factor cash flow factor !"."# value

@iA @iiA @iiiA @ivA > @iiA $ @iiiA

4c 4( @=-A 0. @=-A 0. @=-A

0 22 0 E .- 2/3 .<33 2

1 1/1 0 E .-A1 13= .=- 1

2 -21 0 E .-A2 303 .3/ / NPV 4 !$0

Note: :igures have been rounded up to ne$t whole

number.




Comprehensive

eample$

ou are the 9inance Janager of amanufacturing company% 3lusegunJanufacturing plc% a dealer in Iron 0ods. our company plans to buy a newmachine to meet identi(ed market

demand for a new product. +his machinewill cost >7c1%=??%??? and the machinewill last for four years% at the end of the

four years% the machine will be sold for>7c1??%???. 3lusegun Janufacturingplc e!pects variable cost and sales for

the product to be as follows:10/19/15 By Felix O Boateng 71

ear 1 2 # &



ales units":&#%#?? =?%@?? E=%E??##%D??

+he units produced is the units sold andselling price per unit is >7c2= for year 1and this is e!pected to increase by BA

every year. /ariable cost of productionper unit is >7c12 for year 1 and this ise!pected to increase by 2A every year.

Incremental (!ed cost for year 1 ise!pected to be >7c2B%??? and this ise!pected to increase by EA every year.


+he rate of ta! G depreciation or written



G down allowance applicable to the newmachine is 2=A per annum on a

reducing balance basis.'rior to the management,s decision aswhether to undertake this e!pansion or

otherwise% the management contracteda market research company% ;ata>athering limited to conduct research

on the e!istence of demand for the newproducts. +he fees charged to 3lusegunJanufacturing 'lc amounted to

>7c#??%???.10/19/15 By Felix O Boateng 73

3lusegun Janufacturing 'lc pays ta!



at an annual rate of #?A% but oneyear in arrears. +he appropriate afterG ta! cost of capital discount rate" is11A.

0e)uired:Calculate the net present value ofbuying the new machine and advise

management of 3lusegunJanufacturing 'lc base on your(ndings.

25 mar(s-10/19/15 By Felix O Boateng 74

ase stud)



0ichard oble Ktd is a (rm ofagricultural engineers and plan to invest

>7c2=%??? in a special delivery vehicle. +he vehicle will be purchased in Lanuary2??? and has an estimated useful life of= years% after which its estimated salesvalue will be >7c=%E??.et savings on current contracted outdelivery costs will result in incremental

income8 e!cluding depreciation and thee<ects of ta!ation of >7cD%=??%>7c@%=??% >7cE%???% >7cE%??? and

>7c#%???.10/19/15 By Felix O Boateng 75

+he business pays its ta! in the



p yyear following that in which

pro(ts are earned% at a rate of#?A of ta!able pro(t. +he business makes a net of

ta! return on capital of 1=A%which% for the purposes ofcapital appraisals is consideredto be its cost of capital.hould this project be

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