Capital Expenditure Decisions

1. Should we build
a steel plan

2. INVESTMENT DECISIONS
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3. Investment Decision
 It is the decision related to long term project
demanding huge capital expenditure or
investments.
 They are also known as capital expenditure
decisions
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4. Nature of Investment Decision
 Irreversible
 Return only after long period
 Risky
 Involves huge amount of capital
 Requires expertise
 More financial complexity
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5. Investment Decision Process
A. Project Analysis
B. Feasibility Study
C. Financial Appraisal
D. Capital Budgeting
E. Capital Rationing
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6. A. PROJECT ANALYSIS
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7. Project
 It is a firm’s project to do future business.
 Projects demand present capital investment for
potential future returns.
 Capital demanded by the projects is known as
Investment or capital expenditure
 Future returns are known as cash flows (CFs),
Cash Inflows (CIFs) and free cash flows (FCFs).
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8. Project Analysis
 Each project has its own nature and character
making the project unique
 It is the process of analysing potential business
projects for selection.
 It has multiple stages and different dimensions.
 In order to sort the projects and select one or
more out of them, all projects have to be
analyzed independently.
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9. Types of projects
1. New Project
2. Expansion
3. Mandatory projects: Safety and Legal norms
4. R&D
5. Long Term contract
6. Replacement: Maintenance and Cost Reduction
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10. Project Types
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# Based on Project Types
1 Tenure Short Term Long Term
2 Cash Flows Conventional Non Conventional
3 Risk Stable Cash flows Volatile Cash Flows
4 Investment Capital Intensive Low Capital
5 Relationship Independent Mutually Exclusive
6 Need Mandatory Business
7 Scope New Expansion

11. Independent Vs Mutually Exclusive
 INDEPENDENT
If the cash flows of one are unaffected by the
acceptance of the other.
 MUTUALLY EXCLUSIVE
If the cash flows of one can be adversely impacted
by the acceptance of the other.
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12. An Example of
Mutually Exclusive Projects
Road Way or Rope Way
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13. B. PROJECT FEASIBILITY STUDY
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14. Project Feasibility Study
It is the assessment of practicality of
proposed project/s.
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15. Project Feasibility Study - Types
It is the assessment of practicality of
proposed project/s
 Non Financial Appraisal
 Financial Appraisal
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16. Non Financial Appraisal
1. Technical Appraisal
2. Market Appraisal
3. Economic Appraisal
4. Political Appraisal
5. Legal Appraisal
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17. 1. Technical Appraisal
It is more of Project features including
o Operational difficulties
o Capacity
o Suppliers
o Locational parameters
o Regional factors
o Technology used
o Environmental factors
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18. 2. Market Appraisal
It states the outcomes of market research
o Nearness to market
o Prospective customers
o Competitive factors
o Pricing issues
o Consumer behavior
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19. 3. Economic Appraisal
Economic Factors influencing the project
o Inflation
o Interest rates
o Government policies
o Subsidies
o Tax rates
o Foreign exchange rate in case of an Offshore
project
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20. 4. Political Appraisal
One shouldn’t ignore the power of ruling and
opposition parties influencing the business and
their projects. Following are the classical examples
o Tata Motors Nano Project in West Bengal closed
down due to the influence of TMC.
o Enron’s Dhabol Power project was delayed and
closed due to the differences among ruling BJP
and opposition parties.
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21. 5. Legal Appraisal
One should do an in-depth study on the legal
boundaries and compulsion at the national, state
and regional level.
o Licensing
o Registration
o Minimum requirements in terms of capital, local
employment, contribution to society, social
responsibility, repatriation of profits, etc..
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22. C. FINANCIAL APPRAISAL
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23. C. Financial Appraisal
1. Financial factors
2. Capital Budgeting
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24. 1. Financial Factors
 Project Tenure (n)
 Cost of Capital (k)
 Cash Flows (CFs)
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25. Project Tenure (n)
• It is the life of the project usually mentioned in
years.
• Longer the tenure, more risky is the project.
• Shorter tenure projects are more predictable
and considered to be low risky.
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26. Cost of Capital (k)
• It is the weighted average cost of capital of the
firm (WACC),
• It is denoted as ‘k’
• It the combination of cost of equity and debt with
their respective weights
WACC (k) = weke + wd kd
Where we = Weight of equity
ke = Cost of equity
wd = Weight of debt
kd = cost of debt
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27. Cash Flows (CFs)
They are the cash flows towards the firm and away
from the firm. They can be classified as
1. Cash Out flow (COF) : Investment / Expenses
2. Cash Inflows (CIF) : Returns
3. Net Cash Flows (NCF) : Profits = CIF - COF
If CF Is -ve, it means CIF is > COF
CF is +ve, it means CIF is < COF
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28. Cash Out Flows (Investments)
• Higher the investment, higher the risk and vice
versa.
• Investments are known as cash out flows.
• Cash out flow could be one time or recurring
during the tenure of the project.
• Most of the projects have investment for the first
few years.
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29. Cash In Flows (Returns)
• They usually start few years after the
execution of the project
• They vary periodically over the tenure of the
project or project life.
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30. Cash Flow Sequence
A. Conventional / Normal Cash Flows
• One change of sign in the series of cashflows.
• -Ve CF followed by a series of +Ve cash inflows.
• Investments followed by returns.
B. Non Conventional / Non Normal Cash Flow:
• Two or more changes of signs.
• -Ve CF, then +Ve CFs, then –Ve CFs.
• This happens due to the cost of closing the project.
• Example: Nuclear Power plant.
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31. Inflow (+) or Outflow (-) in Year
0 1 2 3 4 5
- + + + + + N
- + + + + - NN
- - - + + + N
+ + + - - - N
- + + - + - NN
N / NN
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32. Process of Financial Appraisal
1. Forecast project tenure
2. Define Cash Inflows & Outflows of project
3. Assess certainty and Cash flow risk
4. Determine WACC (k)
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33. D. CAPITAL BUDGETING
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34. Capital Budgeting
1. Budget is the tool of planning in any function or
domain.
2. Capital Budgeting is the tool of financial or
investment planning.
3. Alike any budget, it has two counter heads in
planning i.e. Investments (Cash Outflow) Returns
(Cash Inflow)
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35. Tools Of Capital Budgeting
 Traditional Tools
 Accounting Rate of Return (ARR)
 Pay Back Period (PBP)
 Discounting tools
 Net Present Value (NPV)
 Benefit Cost Ration (BCR)
or Profitability Index (PI)
 Internal Rate of Return (IRR)
 Annual Capital Charge (ACC)
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36. Process of Capital Budgeting
1. Select the potential projects after financial after the
feasibility study.
2. Choose the right tool to appraise each project.
3. Arrive at the value of the project using capital budgeting
tool.
4. Develop accept or reject criteria.
5. Arrive at accept or reject decision based on the tools
applied.
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37. E. CAPITAL RATIONING
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38. Capital Rationing
 Rationing is the process of allocating limited resources
to the eligible elements.
 Capital rationing is the process of allocating limited
capital to the feasible projects.
 It occurs when a company cannot fund all the profitable
projects.
 It also occurs when the company chooses not to fund
all positive NPV projects. In this case, the company
typically sets an upper limit on the total amount of
capital expenditures that it will make in the upcoming
year.
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39. Capital Rationing Process
 Evaluate all the projects using capital budgeting.
 Determine the capital available or Set the upper limit of
capital for investment.
 Rank the projects based on the capital budgeting tools
like NPV, IRR and PI.
 Start selecting the projects based on the ranking from
top rank in the descending order.
 Select n number of projects till the capital limit gets
exhausted.
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40. Capital Rationing Process
 All the projects cannot be selected as the capital is
limited.
 All the projects will be fully invested in the selected
projects.
 In some cases, the last project may or may not be fully
invested due to the mismatch of capital availability and
capital required.
 The last project may also be ignored due to non
feasibility of partial investment.
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41. Capital Rationing Example
 Limited Capital : Rs 100 Cr
 Capital Budgeting tool used to Rank: NPV
 Criteria to select the last project in case of partial
investment: Add more capital if available capital after
previous projects allocation is more than 50 %
 Potential Projects: 10
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42. Potential Projects
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Project Capital Required or Cash Outflow
A Rs 40 Cr
B Rs 12 Cr
C Rs 38 Cr
D Rs 25 Cr
E Rs 16 Cr
F Rs 10 Cr
G Rs 42 Cr
H Rs 35 Cr
I Rs 10 Cr
J Rs 50 Cr

43. Projects Ranking based on NPV
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Project Ranking Capital Required / Cash Outflow
I 1 Rs 10 Cr
H 2 Rs 35 Cr
A 3 Rs 40 Cr
C 4 Rs 38 Cr
F 5 Rs 10 Cr
B 6 Rs 12 Cr
D 7 Rs 25 Cr
J 8 Rs 50 Cr
G 9 Rs 42 Cr
E 10 Rs 16 Cr

44. Capital Rationing with Rs 100 Cr
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Project Ranking
Capital
Required
Capital Available for
each project
I 1 Rs 10 Cr Rs 100 Cr
H 2 Rs 35 Cr Rs 90 Cr
A 3 Rs 40 Cr Rs 55 Cr
C 4 Rs 38 Cr Rs 15 Cr
F 5 Rs 10 Cr Rs 10 Cr
B 6 Rs 12 Cr Rs 12 Cr
D 7 Rs 25 Cr Rs 25 Cr
J 8 Rs 50 Cr Rs 50 Cr
G 9 Rs 42 Cr Rs 42 Cr
E 10 Rs 16 Cr Rs 16 Cr

45. Capital Rationing Example
 All 10 projects A,B,C,D,E,F,G,H,I and J are profitable
and feasible based on NPV.
 All projects are ranked based on NPV.
 First 3 projects were selected for investment. i.e.
projects I, H and A.
 Though partial investment was available in project 4 i.e
project C, it is not considered as the available capital is
less than 50% of the required capital for the project.
 though all 10 projects are profitable only 3 projects
were selected using capital rationing.
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46. In case more projects have to be rejected due to capital limitation,
firm do apply following techniques to select one or few projects.
1. Increase the cost of capital: To reflect all direct like floatation
costs and indirect costs.
2. Use linear programming: To maximize NPV subject to not
exceeding the constraints on staffing in engineering, marketing,
administration, management, technology etc due project
diversification
3. Post audit expenses: Managers forecast unreasonable cash
flows.
4. Managers compensation: Tied to the project performance
Capital Rationing
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47. Thank You
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