9 Basics of Capital Expenditure Decisions
9 Basics of Capital Expenditure Decisions
9 Basics of Capital Expenditure Decisions
Dr. Suresh
suresh.suralkar@gmail.com
Phone: 40434399, 25783850
Title
ICMR Ch.
PC Ch.
IMP Ch.
1*
2*
10*
17
20, 21
18*
20, 21, 23
4*
8, 9
4, 5
3*
7 Valuation of Securities
5*
8 Cost of Capital
11*
14
of Capital Expenditure
9 Basics
Decisions
18*
11
12*
10, 11
*Book preference
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Chapter 11
3. Financial Management, I. M. Pandey, 9th Edition,
Chapter 8
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Chance Factors
Regulatory Framework and Policies
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Feasibility Study
Implementation
Project Delays
Performance Review
Aspects of Project Appraisal
Market Appraisal: Size of market, projects market share
Technical Appraisal: Technical aspects, implementation, technology
Financial Appraisal: Risk and returns, cost benefits analysis
Economic Appraisal: Social cost benefit analysis
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be ignored.
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3. Appraisal Criteria:
Discounted and Non - Discounted Methods
Evaluation Criteria
Discounting Criteria
Non-Discounting Criteria
Payback
Period
Accounting
Rate of
Return
(ARR)
Net
Present
Value
(NPV)
Benefit
Cost
Ratio
(BCR)
Internal
Rate of
Return
(IRR)
Annual
Capital
Charge
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the projects, the firm has to decide an appropriate cutoff period. Projects with payback period up to the cut-off
period are accepted and beyond the cut-off period are
rejected.
Advantages of cut-off period method
It is simple in concept and application
It helps in rejecting risky projects and accepting those projects
which generate substantial inflows in earlier years.
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the firm may accept too many short-lived projects and too few
long-lived ones.
Payback period method leads to discrimination against projects
which generate substantial cash inflows in later years, the
criterion cannot be considered as a measure of profitability.
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2.5 - 2.402
3.15 years
3.037 - 2.402
1,20,000
1,00,000
80,000
Operating Expenses
(excluding depreciation)
60,000
50,000
40,000
Depreciation
30,000
30,000
30,000
Annual Income
30,000
20,000
10,000
Investment
Sales Revenue
0
(90,000)
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CF t
NPV
I0
t
t 1 (1 k)
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5,100
5,100
5,100
7,100
(12,500)
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5100
5100
5100
7100
PVIF @ k = 12%
0.893
0.797
0.712
0.636
4554
4065
3631
4516
I
PV
1
I
BCR 1
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Decision Rule
Initial investment
(at year 0)
(20)
7.5
(4.5)
1.5
(7)
2.5
(8)
3.5
Rank
IV
2.5 x PVIFA(14,5) 7
= (2.5 x 3.433) 7
= 1.58
III
3.5 x PVIFA(14,5) 8
II
BCR
Rank
25.75 / 20 = 1.27
II
IV
8.58 / 7
III
12.02 / 8 = 1.50
= 1.23
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CF t
I0
t
t 1 (1 k)
n
CF t
I0 0
t
t 1 (1 k)
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(10)
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With k=18%,
5 xPVIF(0.18,1)+ 4 xPVIF(0.18,2)+ 3 xPVIF(0.18,3)+ 2 xPVIF(0.18,4)
= 5 x 0.847 + 4 x 0.718 + 3 x 0.609 + 2 x 0.516
= 9.966
Next trial with 17%
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By linear interpolation
10.139 - 10
k 17 (18 17) x
10.139 - 9.967
= 17 + 0.80
= 17.80 %
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appraisal.
Advantages of IRR method
It takes into account the time value of money