CAPITAL INVESTMENT APPRAISAL

Capital budgeting refers to budgeting for capital expenditure. It involves long term investment decisions. It is the planned and predetermined allocation of available funds for long term projects so as to achieve maximum returns on investment. Capital budgeting facilitates evaluation of different investment proposals in terms of current outlays and expected benefits and suggests the best. The most obvious examples of capital expenditure are acquisition of assets like land and buildings, plant and machinery etc. IMPORTANCE OF CAPITAL BUDGETING; capital budgeting is very important for the following reasons. 1. 2. 3. 4. 5. 6. 7. Large investment of funds; Long term investment decisions involve huge investment. Since the demand for funds far exceeds the availability, the firm should make a judicious plan of investment. Long term commitment of funds; capital expenditure is more or less permanent in nature and the element of risk involved is greater. Irreversible nature of investment; once the process of investment is over, it is very difficult to reverse it, without incurring huge loss. Long term effect on profitability; Apart from its impact on present earnings, long term investment decisions affect the growth and profitability of the firm. Risk of obsolescence; There is a risk fixed assets being obsolete before the expiry of the normal life of the asset. Loss of flexibility; Once investment has been made in fixed assets, the firm is committed to a particular line of products and technology. A change of product or technology is not easy. Impact on cost structure; Installation of plant and equipment necessitates certain expenses like factory rent, salary to operators, insurance etc. which are fixed in nature. They may prove to be a burden.

Cash flow forecasting; Cash flow forecasting is an essential aspect of capital budgeting. This is usually not an easy affair, it is particularly acute in capital budgeting in view of the long period of time involved. I t is therefore important to consider the impact of variation in estimates of cash flows on the investment decision. We proceed under the assumption that future cash flows are known with certainty. Methods of investment appraisal; Numerous investment evaluation techniques are available in assisting investment decisions.

NON-DISCOUNTED METHODS
Payback period method; Payback period is the period within which the initial investment is completely recovered. The various investment proposals are ranked on the basis of payback period and the one, which repays the initial investment in the shortest period, is selected. This method is particularly suitable for projects in respect of which the risk obsolescence is greater. The investment or at least a portion of the investment will be recovered, before the project becomes obsolete. Advantages 1. 2. 3. Simple. Time and effort involved is less and hence less expensive. Lower chance of loss by obsolescence since the original investment is recovered an early date. Early realization of investment enhances the liquidity of the firm. a.

Disadvantages 1. 2. 3. 4. Ignores the cash inflow beyond the payback period; the profitability of the project is not considered. Profitability is an important aspect to be considered while making investment decisions. Does not take the time value of money into account. Cash inflows occurring at different points of time are considered alike. Cost of capital is very important while making investment decisions. This is altogether ignored. This method places undue emphasis on liquidity and ignores return on capital employed. 1

Raa Atoll Education Centre / Grade 12/ Accounting

b. Accounting Rate of Return (ARR) Under this method the expected earnings from the investment over the whole life of the asset are taken into account. Earnings correspond to cash inflow minus depreciation. (Profit may be before or after tax). Projects are ranked on the basis of ARR and the one with the highest ARR is accepted. If there is only one project in hand acceptance / rejection decision is taken on the basis of the predetermined target rate.

Average annual profits ARR = Average investment

1. 2. 3. 4. Advantages Easy to calculate and simple to understand It takes into account the entire earnings over the economic life of the asset This is based on the accounting concept of profit It gives importance to profitability rather than liquidity Disadvantages Ignores the time value of money Ignores the timings of profits; profits may be higher in earlier years and lower in later years and vice versa Profits has subjective elements; it varies according to the concepts and conventions used in accounting.

X 100

1. 2. 3.

DISCOUNTED CASH FLOW METHODS

1. 2. The discounted cash flow methods are superior to traditional methods in two respects. They take into account: The time value of money The cash inflows during the whole life of the project Time value of money: Investment in projects is made with a view to earning profits. Therefore the future expected returns from the investment must be greater than the investment must be greater than the investment, if it is to be worthwhile. The concept of time value of money is that a dollar received today is far more valuable than a dollar received tomorrow, because $1 if invested today will grow to a larger sum in future. Present value: Present value is the amount a future cash flow is worth in terms of today s money. Sums arising at different points of time cannot be compared or added up together while making investment decisions. Therefore they reduced to equivalent values at some common date. The discounted cash flow methods use now , i.e. the present times as the common date. The discounted cash flow methods are discussed below: a. Net present value method: Net present value is the net difference between the cash inflows and out flows expected to arise at different periods of time, in present value terms. The step by step procedure of evaluation is as follows: y Determine a suitable rate of interest that reflects the minimum expected rate of return y Compute the present value of all cash out flows. (if the total investment is made at the beginning of the period the present value of the same is taken to be the same as the cost investment) y Compute the present value of all cash inflows (profit before depreciation and after tax). The scrap value at the end of the period is also considered as cash inflows. y The excess of total present value of cash inflows over total present value of cash out flows represent the net present value. y The investment proposal with zero or positive net present values is then ranked and the one with the highest net present value is selected. y In the case of a single project, if the net present value is zero or positive, it can be accepted and if not rejected. Raa Atoll Education Centre / Grade 12/ Accounting 2

Advantages 1. 2. 3. 4. It considers the total cash inflows over the life of the project It is based on profitability rather than liquidity It takes time value of money into account Computation is on the basis of cost of capital

Disadvantages 1. 2. 3. Computation is difficult when compared to traditional methods Life of the asset is ignored. There is a chance of going for a risky long period project rather than accepting a less risky project eventhough net present value is slightly less. It may not be reliable while comparing projects with unequal investments because net present value is expressed in absolute terms.

b. Internal Rate of Return (IRR): Internal rate of return is the discounted rate at which the net present value is zero. It is that discount rate which equates the present value of cash inflows with the present value of cash outflows. If the project earns a higher rate of return than the cost of capital, it will be accepted; if not rejected. IRR = LR + [ (HR LR) X Advantages 1. 2. 3. It takes into account the entire earnings over the economic life of the asset Cost of capital is considered for decision making As IRR is expressed as a percentage, ranking of the proposal is made on a uniform basis
   

Disadvantages 1. 2. 3. The process of computation is rather cumbersome It does not consider the life span of assets The method ignores the concept of liquidity

Cost of Capital: Companies raise their capital from various sources. Cost of capital is the Average rate of return that has to be paid to the various provider of capital. Cost of capital is calculated by taking into account dividends to be paid to the shareholders and the interest to be paid to the debentures and loan. Cost of capital =
  

x 100

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NON-FINANCIAL INVESTEMENT APPRAISAL FACTORS

A lot of businesses do not pay attention to non- monetary and non-financial factors of investment appraisal process. Unknown to this group of businesses is the fact that some of these non-financial factors carry more weight than the so-called financial parameters of investment appraisal. Non financial investment appraisal factor can reduce an already established business empire from zero if not carefully handled. Non-financial investment appraisal factors. Below are some of those non-financial factors:  Climatic issues: green activities has extent that companies not investing in equipment that preserves the environment are seen as a non- responsive and irresponsible by the public who will in turn become customers later. In order for companies to preserve this benefit, it sometimes has to invest in some projects that are not too financially sound.  Staff motivation: the effect of an investment of the staff should be considered before furthering in the investment process.  Backend profit/ sales: Another non-financial factor to consider is the backend sales that will come to the company as a result of investing in some non- profitable projects. This will act as a bait to bring in customers that may eventually see another product that they may like.  Customer s satisfaction: the satisfaction that the customers will get from an investment is a non- financial factor to consider before making any investment. After all, customers are always king.  Availability of man power: the company needs to take sure that there is enough manpower to operate the equipments to be invested in.  Government regulations: this is an obvious but the most neglected aspect of investment appraisal. There is need to consider the government relevant laws before making investment appraisal.  Competitor s action: there is need to consider the action of your competitors before making investment decisions. This will in most cases lead to companies making investments that are not purely based on financial backgrounds.

Raa Atoll Education Centre / Grade 12/ Accounting