LOC 1 AC 2 Capital Expenditure Evaluation For Long Term Plan

Capital expenditure situation is one in which the companys funds are committed to projects which will return the invested funds and profit during future periods. The objective is to evaluate from alternatives the project (investment) which will promote the profitability and longrange growth of the enterprise. These evaluation methods simply act as a guide and help communicate useful information to the decisionmaker. The actual decision is based on many diverse factors which cannot be incorporated into an overall formula or technique. In making economic comparisons it is important to ensure that the various alternatives are substantially equivalent, particularly with regard to their technical specification and performance characteristics. Traditional methods includes, (1) Payback, (2) Return on capital employed and (3) Discounted cash flow method. (1) Payback To determine the number of years it takes to payback the original investment from profits arising from the investment. Project can be considered on (a) An accept-reject basis depending on the payback period, or (b) Project ranking, where the fastest paying-back project is accepted from a number of mutually exclusive projects. (2) Return on Capital Employed is a ratio that indicates the efficiency and profitability of a companys capital investments. Thus, it is a indicator of how well a company is utilizing capital to generate revenue. The ROCE is done by taking profit before interest and tax (EBIT) and dividing that by the difference between total assets and current liabilities. Formula: ROCE = EBIT / (Total assets Current Liabilities) Or, ROCE = Operating Profit / Equity Shareholders Funds

(3) Discount cash flow method which consists of : (a) Net Present Value (NPV) (b) Internal Rate of Return (IRR) Net present value (NPV) is a standard method for the financial appraisal of long-term projects. Used for capital budgeting, and widely throughout economics, it measures the excess or shortfall of cash flows, in present value (PV) terms, once financing charges are met. By definition, NPV = Present value of net cash flows. For its expression, see the formula section below. Formula Each cash inflow/outflow is discounted back to its PV. Then they are summed. Therefore

Where t - the time of the cash flow n - the total time of the project r - the discount rate Ct - the net cash flow (the amount of cash) at time t. C0 - the capital outlay at the beginning of the investment time ( t =0) The Discount Rate The rate used to discount future cash flows to their present values is a key variable of this process. Most firms have a well defined policy regarding their capital structure, so the weighted average cost of capital (after tax) is used with all projects. Some people believe that it is appropriate to use higher discount rates to adjust for risk for riskier projects. Another method is to use a variable discount rate with higher

rates applied to cash flows occurring further along the time span, (reflecting the yield curve premium for long-term debt). Another approach to choosing the discount rate factor is to decide the rate which the capital needed for the project could return if invested in an alternative venture. If, for example, the capital required for Project A can earn five percent elsewhere, use this discount rate in the NPV calculation to allow a direct comparison to be made between Project A and the alternative. Related to this concept is to use the firm's Reinvestment Rate. Reinvestment rate can be defined as the rate of return for the firm's investments on average. When analyzing projects in a capital constrained environment, it may be appropriate to use the reinvestment rate rather than the firm's weighted average cost of capital as the discount factor. It reflects opportunity cost of investment, rather than the (typically) lower cost of capital. NPV value obtained using variable discount rates (if they are known) with the years of the investment duration better reflects the real situation than that calculated from a constant discount rate for the entire investment duration. Refer to the tutorial article written by Samuel Baker[1] for more detailed relationship between the NPV value and the discount rate. For some professional investors, their investment funds are committed to target a specified rate of return. In such cases, that rate of return should be selected as the discount rate for the NPV calculation. In this way, a direct comparison can be made between the profitability of the project and the desired rate of return. To some extent, the selection of the discount rate is dependent on the use to which it will be put. If the intent is simply to determine whether a project will add value to the company, using the firm's weighted average cost of capital may be appropriate. If trying to decide between alternative investments in order to maximize the value of the firm, the corporate reinvestment rate would probably be a better choice. Using variable rates over time, or discounting "guaranteed" cash flows different from "at risk" cash flows may be a superior methodology, but

is seldom used in practice. Using the discount rate to adjust for risk is often difficult to do in practice (especially internationally), and is really difficult to do well. An alternative to using discount factor to adjust for risk is to explicitly correct the cash flows for the risk elements, then discount at the firm's rate. What NPV Means NPV is an indicator of how much value an investment or project adds to the value of the firm. With a particular project, if Ct is a positive value, the project is in the status of discounted cash inflow in the time of t. If Ct is a negative value, the project is in the status of discounted cash outflow in the time of t. Appropriately risked projects with a positive NPV be accepted. This does not necessarily mean that they should be undertaken since NPV at the cost of capital may not account for opportunity cost, i.e. comparison with other available investments. In financial theory, if there is a choice between two mutually exclusive alternatives, the one yielding the higher NPV should be selected. The following sums up the NPVs in various situations.

If... It means...

Then...

the investment NPV would add value the project may be accepted >0 to the firm the investment NPV would subtract the project should be rejected < 0 value from the firm We should be indifferent in the decision the investment whether to accept or reject the project. This NPV would neither gain project adds no monetary value. Decision = 0 nor lose value for should be based on other criteria, e.g. strategic the firm positioning or other factors not explicitly included in the calculation.

However, NPV = 0 does not mean that a project is only expected to break even, in the sense of undiscounted profit or loss (earnings). It will show net total positive cash flow and earnings over its life. Example X corporation must decide whether to introduce a new product line. The new product will have startup costs, operational costs, and incoming cash flows over six years. This project will have an immediate (t=0) cash outflow of $100,000 (which might include machinery, and employee training costs). Other cash outflows for years 1-6 are expected to be $5,000 per year. Cash inflows are expected to be $30,000 per year for years 1-6. All cash flows are after-tax, and there are no cash flows expected after year 6. The required rate of return is 10%. The present value (PV) can be calculated for each year: T=0 -$100,000 / 1.100 = -$100,000 PV. T=1 ($30,000 - $5,000) / 1.101 = $22,727 PV. T=2 ($30,000 - $5,000) / 1.102 = $20,661 PV. T=3 ($30,000 - $5,000) / 1.103 = $18,783 PV. T=4 ($30,000 - $5,000) / 1.104 = $17,075 PV. T=5 ($30,000 - $5,000) / 1.105 = $15,523 PV. T=6 ($30,000 - $5,000) / 1.106 = $14,112 PV. The sum of all these present values is the net present value, which equals $8,881. Since the NPV is greater than zero, the corporation should invest in the project. The same example in an Excel formulae:

NPV(rate,net_inflow)+initial_investment PV(rate,year_number,yearly_net_inflow)

More realistic problems would need to consider other factors, generally including the calculation of taxes, uneven cash flows, and salvage values as well as the availability of alternate investment opportunities. The internal rate of return (IRR) is a capital budgeting metric used by firms to decide whether they should make investments. It is an indicator of the efficiency of an investment (as opposed to NPV, which indicates value or magnitude). The IRR is the annualized effective compounded return rate which can be earned on the invested capital, i.e. the yield on the investment. A project is a good investment proposition if its IRR is greater than the rate of return that could be earned by alternative investments (investing in other projects, buying bonds, even putting the money in a bank account). Thus, the IRR should be compared to an alternative cost of capital including an appropriate risk premium. Mathematically the IRR is defined as any discount rate that results in a net present value of zero of a series of cash flows.

In general, if the IRR is greater than the project's cost of capital, or hurdle rate, the project will add value for the company. Method To find the internal rate of return, find the IRR that satisfies the following equation: The IRR uses the NPV equation as its starting point: Calculating the IRR is done through a trial-and-error process that looks for the Discount Rate that yields an NPV equal to zero. The trial-and-error calculation can by accomplished by using the IRR function in a spreadsheet program or with a programmable calculator. The graph below was plotted for a wide range of rates until the IRR was found that yields an NPV equal to zero (at the intercept with the x-axis). As in the example above, a project that has a discount rate less than the IRR will yield a positive NPV. The higher the discount rate the more the cash flows will be reduced, resulting in a lower NPV of the project. The company will approve any project or investment where the IRR is higher than the cost of capital as the NPV will be greater than zero.

The IRR is therefore the maximum allowable discount rate that would yield value considering the cost of capital and risk of the project. For this reason, the IRR is sometimes referred to as a break-even rate of return. It is the rate at which the value of cash outflow equals the value of cash inflow. There are some special situations where the IRR concept can be misinterpreted. This is usually the case when periods of negative cash flow affect the value of IRR without accurately reflecting the underlying performance of the investment. Managers may misinterpret the IRR as the annual equivalent return on a given investment. This is not the case, as the IRR is the breakeven rate and does not provide an absolute view on the project return. Problems with using IRR (Further Readings) As an investment decision tool, the calculated IRR should not be used to rate mutually exclusive projects, but only to decide whether a single project is worth investing in. In cases where one project has a higher initial investment than a second mutually exclusive project, the first project may have a lower IRR (expected return), but a higher NPV (increase in shareholders' wealth) and should thus be accepted over the second project (assuming no capital constraints). IRR makes no assumptions about the reinvestment of the positive cash flow from a project. As a result, IRR should not be used to compare projects of different duration and with a different overall pattern of cash flows. Modified Internal Rate of Return (MIRR) provides a better indication of a project's efficiency in contributing to the firm's discounted cash flow. The IRR method should not be used in the usual manner for projects that start with an initial positive cash inflow (or in some projects with large negative cash flows at the end), for example where a customer makes a deposit before a specific machine is built, resulting in a single positive cash flow followed by a series of negative cash flows (+ - - -). In this case the usual IRR decision rule needs to be reversed.

If there are multiple sign changes in the series of cash flows, e.g. (- + + -), there may be multiple IRRs for a single project, so that the IRR decision rule may be impossible to implement. Examples of this type of project are strip mines and nuclear power plants, where there is usually a large cash outflow at the end of the project. In general, the IRR can be calculated by solving a polynomial. Sturm's Theorem can be used to determine if that polynomial has a unique real solution. Importantly, the IRR equation cannot be solved analytically (i.e. in its general form) but only via iterations. A critical shortcoming of the IRR method is that it is commonly misunderstood to convey the actual annual profitability of an investment. However, this is not the case because intermediate cash flows are almost never reinvested at the project's IRR; and, therefore, the actual rate of return (akin to the one that would have been yielded by stocks or bank deposits) is almost certainly going to be lower. Accordingly, a measure called Modified Internal Rate of Return (MIRR) is used, which has an assumed reinvestment rate, usually equal to the project's cost of capital. Despite a strong academic preference for NPV, surveys indicate that executives prefer IRR over NPV. Apparently, managers find it easier to compare investments of different sizes in terms of percentage rates of return than by dollars of NPV. However, NPV remains the "more accurate" reflection of value to the business. IRR, as a measure of investment efficiency may give better insights in capital constrained situations. However, when comparing mutually exclusive projects, NPV is the appropriate measure. In addition if the NPV of one project is higher than another and the other project has a higher IRR, then the cross over point method can be used to solve this dispute. Cross Over Point > IRR = Accept project with higher NPV and if the Cross Over Point < IRR = Accept project with higher IRR

Question 1 Maju Indah Sdn Bhd has 2 construction projects planned for investment. However, due to limitation on capital, only 1 project will be selected and implemented. The initial investment and payback amount for the projects are as follows: Year Year 0 Year 1 Year 2 Year 3 Year 4 Project 1 (million-RM) -100 +30 +40 +50 +60 Project 2 (million-RM) -100 +60 +40 +30 +20

(a) Determine the payback period for the projects. (b) Determine the total net profit, using the net present values (based on 14% interest rate), for the projects. (c) Analysis the Internal Rate of Return for the projects. (d) Comment to your management for which construction project should be chosen based on the outcomes in (a), (b) and (c). Question 2 Houseman Sdn Bhd has 2 alternatives to invest their construction project. One is to purchase a machine X, with smaller capacity, and replace it after 2 years time. Another option is purchase higher capacity; machine Y, to be used for all project life. The cost of investment and payback amounts are shown as follows : Year Year 0 Year 1 Year 2 (Reinvestment ) Year 3 Year 4 Machine X (RM) -45,000 +24,000 +38,000 -45,000 +24,000 +38,000 Machine Y (RM) -53,000 +15000 +25,000 +30,000 +10,000

Determine which machine is strongly suggested to be purchase in order to optimize the profit return. (Assume that interest rate is 14%)

(Answer : Machine X, with NPV RM 9,366)

Classroom Exercise - Question 1 (Internal Rate of Return) Internal Rate of Return Computation Statement for Project 1 Duration Initial Cashflow Case 1 0% Case 2 14% Case 3 20% PV Factor PV PV Factor PV PV Factor PV 0 -100 1 -100 1 -100 1 -100 1 30 1 30 0.877193 26.31579 0.833333 25 2 40 1 40 0.769468 30.7787 0.694444 27.77778 3 50 1 50 0.674972 33.74858 0.578704 28.93519 4 60 1 60 0.59208 35.52482 0.482253 28.93519 NPV NPV 80 26.3679 10.6481 -9.48846 Year 0% 14% 20% 30% 80 26.36788 10.64815 Proved 24.89% Case 4 30% PV Factor PV PV Factor PV 1 -100 1 -100 0.8007046 24.02114 0.769231 23.07692 0.6411279 25.64512 0.591716 23.66864 0.5133541 25.6677 0.455166 22.75831 0.411045 24.6627 0.350128 21.00767 -0.003345 -9.488463

IRR Chart for Project 1

100 Net Present Value (RM) 80 60 40 20 0 -20 0% 14% 20% 30% IRR Rate (%) NPV Year

Internal Rate of Return Computation Statement for Project 2 Proved Duration Initial Cashflow Case 1 0% Case 2 14% Case 3 20% PV Factor PV Factor PV PV Factor PV PV Factor PV 0 -100 1 -100 1 -100 1 -100 1 1 60 1 60 0.877193 52.63158 0.833333 50 0.8126778 2 40 1 40 0.769468 30.7787 0.694444 27.77778 0.6604452 3 30 1 30 0.674972 20.24915 0.578704 17.36111 0.5367291 4 20 1 20 0.59208 11.84161 0.482253 9.645062 0.4361878 NPV NPV 50 15.501 4.78395 -9.51997 Year 0% 14% 20% 30% 50 15.50103 4.783951

23.05% PV -100 48.76067 26.41781 16.10187 8.723756 0.004102

Case 4 PV Factor 1 0.769231 0.591716 0.455166 0.350128

30% PV -100 46.15385 23.66864 13.65498 7.002556 -9.519975

IRR Chart for Project 2

60 50 40 30 20 10 0 -10 -20

Net Present Value (RM)

NPV Year 0% 14% 20% 30%

IRR Rate (%)