Capital Expenditure and Investments

Capital Expenditure (CapEx)

 Capital Expenditures refer to funds used by the company to acquire, upgrade, and
maintain physical assets such as PPE.

 CapEx is often used to undertake new projects or investments by the firm. It can include
everything from repairing a roof to building, to purchasing a piece of equipment, or
building a brand new factory.

Capital Investment

 Capital investment refers to funds invested in a firm or enterprise for the purpose of
furthering its business objectives.

Identifying Potential Investment Opportunities

 The fourth step in the capital budgeting process is evaluating project proposals. Capital
investments are evaluated under certainty or risk.

 Under certainty, the exact values associated with the investment, such as the cash flows
and the required rate of return, are known in advance.

 Under risk, variables required for evaluating investment proposals are not certain and
involve a margin of error.

Methods and Techniques used in Appraising Capital Investments

 Return on Capital Employed (ROCE)

 Payback
 Discounting based methods
 Internal Rates of Return
 Accounting Rate of Return
 Net Present Values
 Capital Rationing
 Lease or Buy Decisions

Income Taxes

 Most firms, other than not-for-profit entities and government agencies, must pay income
taxes.
 Firms that pay income taxes must consider the effect of these taxes on cash flows.
 Revenues and related cash inflows generated by an investment increase taxable income
and therefore the taxes must be paid.
 Expenses and the related cash outflows reduce taxable income.

Cash Flow before Taxes Adjustment to Get After-tax

Cash Flows
 Investment cash outflow No adjustment necessary;
cash flow does not affect
taxable net income

 Working Capital cash outflow No adjustment necessary;

and inflow cash flow does not affect
taxable net income

 Revenue cash inflow Multiply by (1-tax rate)

 Expense cash outflow Multiply by (1-tax rate)

 Depreciation before Adjustment to Get After-tax

o Taxes Cash Flows

 Depreciation expense Multiply by tax rate

Example:

 The management of SP, Inc., is considering a five-year contract to build scientific

instruments. The initial investment required is $400,000 (to be depreciated over 5 years
using the straight-line method, with no salvage value). An additional $50,000 in working
capital is required for the contract. Working capital will be returned at the end of five
years. Annual net cash receipts from daily operations (cash receipts minus cash
payments) are shown as follows.
 Year 1 $ 50,000
 Year 2 $ 60,000
 Year 3 $120,000
 Year 4 $200,000
 Year 5 $130,000

 Management established a required rate of return of 10 percent for this proposal. The
company’s tax rate is 40 percent.

 Amount equals net cash receipts before taxes × (1 – tax rate).

 o For year 1, $30,000 = $50,000 × (1 – 0.40);
o for year 2, $36,000 = $60,000 × (1 – 0.40); and so forth.

 Depreciation tax savings = Depreciation expense × Tax rate. Depreciation expense is

$80,000 (= $400,000 cost ÷ 5 year useful life). Thus annual depreciation tax savings is
$32,000
o (= $80,000 depreciation expense × 0.40 tax rate).

 Investment Cash Outflows. The initial investment in production equipment of $400,000

is not adjusted for income taxes because it does not directly affect net income.
 Working Capital Cash Outflows and Inflows. Working capital of $50,000 is not
adjusted for income taxes since it does not affect net income.
 Revenues and Expenses. When a company must pay income taxes, all revenue cash
inflows and expense cash outflows affect net income and therefore affect income taxes
paid. The goal is to determine the after-tax cash flow. This is calculated in the equation
that follows.

 The tax rate for Scientific Products, Inc., is 40 percent. Thus net cash receipts (revenue
cash inflows minus expense cash outflows) are multiplied by 0.60 (= 1 – 0.40).
 Depreciation. Although depreciation expense is not a cash outflow, it does reduce
taxable income and thereby reduces taxes that are paid
 The term used to describe this tax savings is depreciation tax shield.
 Inflation
 Real Pesos: The amount the future cash flow will be if the inflation rate is zero. [If there
is inflation, then nominal the cash flow will be higher.]
 Nominal Pesos: The amount the cash flow will be, allowing for inflation. This is the
actual dollars to be received at a future date.

 Let: i be the rate of inflation,

 t be the tax rate, Rn be the
nominal pre-tax rate of return, rn be the nominal after-tax
rate of return,
 Rr real pre-tax rate of return, and
 rr real after-tax rate of return.

 Rn = (1 + Rr)(1 + i) − 1
 rn = (1 + rr)(1 + i) − 1
 rn = Rn(1 − t)
 rr = Rr(1 − t) − it /(1 + i)
 Nominal rate = (1 + Real rate) × (1 + Inflation rate) − 1

 After-tax nominal rate = Before-tax nominal rate × (1 − Tax rate)

Methods of Estimating and Measuring Risk
1. Scenario Analysis
2. Sensitivity Analysis
3. Simulation Analysis
4. 4. Beta Estimation

Scenario Analysis

 Involves the determination of what happens to NPV estimates when we ask what-if
questions
For example:
o What if unit sales realistically should be projected at level XXX units instead of
XX units?
Scenario Analysis

 Starting point is the worst-case or pessimistic scenario that shows the lower bounds or
minimum NPV of the project
 Then go ahead to the other extreme, the best case or optimistic scenario

Sensitivity Analysis

 Useful in pinpointing which variables should be given more attention

Simulation Analysis
 Combination of scenario and sensitivity analysis

Beta Estimation
 Involves concept of Capital Asset Pricing Model (CAPM)
 Beta is a measure of the systematic risk of a project

Systematic Risk Principle

o - states that the reward of bearing risk depends only on that asset’s
systematic risk
Beta Coefficient
- specific amount of systematic risk present in a particular risky
asset relative to that in average risky asset