Prof Rajasree, IBS Kochi MBA, MS, CFA

Capital Expenditure
Decisions
Sem1
FM 1
Capital Expenditure Decision
Also called capital budgeting.
A decision which involves companys 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.


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
Preliminary Screening
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 1
st
,
12 crore in 2
nd
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 33
1/3
% 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


Non Discounting


Discounting
Payback period
Accounting rate of return
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