Class 1 (2)

Capital expenditure and revenue

expenditure
Capital Expenditure

Revenue Expenditure

Obtain benefits: Longperiod of time

In statement of financial
position

Outflow: large amount of

cash

Inventories + trade
receivables trade
payables

Benefits:
Extra net
benefits
Cost reduction

WC Investment =
Operating profit Cash
returns the organisation
receives

Non-current asset investment and working

capital investment

A capital investment in non-current

assets will lose value over the life
of the project, and the asset might
have no value at all at the end of
the project.

Working capital investment, on the

other hand, will be recovered at
the end of the project.

Example
A company makes an investment in a non-current asset
costing $50,000. The asset has a life of three years, and
the net operating profit from the asset, ignoring
depreciation costs, will be $20,000 in Year 1, $30,000 in
Year 2 and $25,000 in Year 3. The project will require an
investment of $15,000 in working capital.
What are the cash flows of this project?

Example
Year

Capital
expenditur
e

Working
capital
investme
nt

(50,000)

(15,000)

Net
Net cash
operating
flow
profit
pa

20,000

30,000

15,000

25,000

Cumulat
ive net
cash
flow

$
(65,000
(65,000)
)
(45,000
20,000
)
(15,000
30,000
)
40,000 25,000

What are the ASSUMPTIONS?

Cash flows :

at the end of the period

if beginning: at the end of previous period

What are the ASSUMPTIONS?

Capital investments:

Takes place now (period that has just ended)

Recovery of Working Capital:

End of the project

Investment decisions

Undertake an investment?

Alternative; mutually exclusive project?

Capital rationing project?

Project

Steps in project appraisal

Key stages in Formal Decision Making and Control Cycle

Identification
Origination of Projects
L% Problems
identified
Q New
opportunities
Aligned with
long-term objectives?

Initial
proposal

APPROVAL

Identification

Management must ensure

project is established with clear terms

of reference

an appropriate management structure

a carefully selected project team

Identification

study,

discuss and

analyse the problem,

from a number of different aspects (e.g. technical,

financial,
managerial etc.) so must have the appropriate skills and
authority to carry out the task.

Appraisal

Appraisal: Elements

Feasibility study and

Risk assessment
Finance source selection

Appraisal has a number of elements

Feasibility study and financial appraisal

To assess whether an investment is worthwhile?

Undertaken by a selected team
All aspects needs to be covered
Appropriate for large and complex projects
If the project can be achieved within acceptable
cost and time constraints.

Appraisal

Appraisal

Feasibility study and

Worthwhile?
Selected team
Risk assessment
Finance source selection

A selected team: How they should

be appointed?

Members drawn from the departments affected by the

investment

One person must have relevant detailed technical knowledge

One other person must be able to assess the organisational

implications of the new system

Hire consultants to carry out the feasibility study (lack of

knowledge of business)

Suitable personal qualities (committee should consider)

Appraisal

Appraisal

1.

Feasibility study and

five key areas in which
a project must be feasible
Risk assessment
Finance source selection

Operational feasibility

Technically sound but conflicts with

business operational methodologies
such as:

a change in management responsibilities

status and chains of command,

does not suit regional reporting structures

the costs of redundancies, retraining and

reorganisation are high

Appraisal

Appraisal
2.

Feasibility study and

five key areas in which
a project must be feasible
Risk assessment
Finance source selection

Technical feasibility

Considerations should include:

Volume of transactions that can be processed

within a given time
Capacity to hold files or records of a certain size
Response times (how quickly the computer does
what you ask it to)
Number of users that can be supported without
deterioration in the other criteria

Appraisal

Appraisal
3.

Feasibility study and

five key areas in which
a project must be feasible
Risk assessment
Finance source selection

Social feasibility

Areas included are:

Personnel policies
Redrawing of job specifications
Threats to industrial relations
Expected skills requirements
Motivation

Appraisal
4.

Appraisal

Feasibility study and

five key areas in which
a project must be feasible

Ecological feasibility

Relates to environmental considerations;

May be rejected if harmful to environment.

Issues include are:

What waste products are produced?

How is waste disposed of?
Is use of the product likely to damage the
environment?
Could the production process be 'cleaner'?
How much energy does the process consume?

Appraisal

Appraisal
5.

Feasibility study and

five key areas in which
a project must be feasible
Risk assessment
Finance source selection

Economic feasibility

Any project will have economic

costs and economic benefits.
Economic feasibility has three
strands.

The benefits must justify the costs

The project must be the best option
from those under consideration for its
particular purpose
Importance of other business needs?

Appraisal

Appraisal

Feasibility study and

Risk assessment
Finance source selection

Appraisal has number of elements

Risk assessment:
Risks identification
Ranking: how serious? Likelihood of
taking place
TARA: Transfer; Accept; Reduce
(minimise); Avoid (eliminate)
Review of risk situations
Financial risks: sensitivity or scenario
analysis

Appraisal

Appraisal

Finance source selection

Available alternative sources

Methods of selection

Feasibility study and

Risk assessment
Finance source selection

Proposal

Proposal is the next step after feasibility study

A formalised document:

Business case

Way of finance

The contents of the proposal will largely follow

on directly from the feasibility study

Results from various studies (feasibility) in

report appendices

Allows executives to draw conclusion

Proposal

Format:

An executive summary

Detail of the report

The conclusion

Recommendations

Appendices

Approval and authorisation

Depends on financial and strategic significance

Senior managers authorise small projects

Directors authorise larger projects

Full board of directors authorise most significant projects

Those making the decision must be satisfied that an appropriatelydetailed evaluation has been carried out, that the proposal meets the
necessary criteria to contribute to profitability, and that it is consistent
with the overall strategy of the enterprise.

Approval and authorisation

Benefits

Controllability (budgetary control): CAPEX - large

amounts of spending and resource utilisation

Earlier assessment whether CAPEX need to be

reversed saves time, costs, etcs.

Strategic and tactical plans - A formal process of

project appraisal and approval is a way of checking
consistency with strategic objectives

A formal appraisal procedure provides an

opportunity for assessing the risk - estimates of
future returns will inevitably be uncertain

Implementation

Assigning projects to project manager /

responsible person

Ensure availability of resources

Coordination of people / resources

Two phases:

Design and development

Distribution

Monitoring and control

Monitor & measure progress

Take corrective action

Overall project plan: enable the business to monitor

project delays, highlight resource and time
constraints, and also project date constraints

Followed by detailed project plans and budgets

describing the tasks, resources and links.

Quality assurance: standards set before commencing

and evaluating existing standards

Cost control: monitor actual against planned

expenditure

Review of performance: actual against planned

corrective actions (if necessary)

Performance review and

post implementation audit

Factors include:

What is evaluated

Who decides what constitutes performance and

whether it is good or bad

Does the investment have a single clear purpose, or a

number of different purposes which will complicate the
targets that are set for it

How important will quantitative measures be and how

important will qualitative measures be

Whether the investment is generating the expected

positive cash flows

Whether it is fulfilling other targets,

Performance review and

post implementation audit

Key success indicators:

Number of customer complaints and

warranty claims

Rework

Delivery time

Non-productive hours

Machine down time

Stock-outs

Methods of project
appraisal

Basic Techniques

Methods of
Project Appraisal

DCF Techniques

Accounting Rate of
return (ARR)

Net Present Value

(NPV)

Payback

Annuities
Perpetuities
Internal Rate of
Return (IRR)

Non-financial factors in a
capital investment decision

Factors affecting include:

Legal issues: risk legal action against the company as a

Ethical issues: Unethical investments damaging public

reputation

Government regulations: the risk of government regulation

Political issues and regulatory issues: future change of

government affect the future returns from an investment;
political uncertainty persuades deferment of investment
decisions

Quality issues: customer relations;

Employee issues: impact on employee relations, motivation

and working culture might need to be considered.

The accounting rate of

return (ARR) method

The accounting rate of

return (ARR) method

A traditional approach to evaluating investments is to evaluate the profit from the investment as a %
of the amount invested.

ROCE is also called accounting rate of return (ARR) and return on investment (ROI).

Formulae:

The accounting rate of

return (ARR) method

Example 1: ARR

Solution to Example 1:
ARR
Profit calculation:

Total cash flows from operations 540,000

Total depreciation (500,000 350,000) (150,000)
Total profits 390,000
Average profits ( 6) =

65,000 p.a.

Investment calculation:
500,000 + 350,000

2
ARR = 65 / 425

15.3%

425,000

Example 2: ARR

Solution to Example 2:
ARR

Advantages ARR

Disadvantages of ARR
method

The payback method

Payback period = [Initial payment Annual Cash Flow]

Payback = the time required for the cash inflows

from a project to recoup the cash outlays.

Initial screening method

Decision rule: Accept all projects with a payback

period within the company's target payback
period.

If cash flows are uneven then payback is calculated

using the cumulative cash flow over the life of the
investment.

Project Payback
calculation

Example 1: Payback
Method

Solution to Example 2:
Payback Method

Solution to Example:
Payback Method

Example 2: Payback
Method

Solution to Example:
Payback Method
Time

Cumulative cash flows

(500,000)

(430,000)

(360,000)

(280,000)

(180,000)

(80,000)

40,000

Payback = 5 + (80/120*12months) = 5 years 8 months

Long payback period
Risky project; there may be no buyer of the project after 6 years!
Consideration for total cash flows from the project

8 The payback and ARR

methods in practice
Reasons for wide usages of Payback

Ranking projects; scenario: liquidity constraints;

objective: fast repayment.
Situations: risky investments in uncertain markets
(fast design & product
changes) or (difficulty in predicting future cash
flows).
Availability of early cash flows data; more
confidence.
in conjunction with the NPV or IRR method acts as a
first screening device.
It is easily understood by all levels of management.
It provides an important summary method: how
quickly will the initial investment

7.3 Advantages & Disadvantages

of the payback method