Capital expenditures are very important for three interrelated reasons: (1) they have long term consequences (2) they are difficult to reverse, and (3) involve substantial outlays.
Capital budgeting, a complex process, may be divided into the following phases: (1) identification of potential investment opportunities, (2) assembling of investment proposals, (3) decision making (4) preparation of capital budget and appropriations, (5) implementation, and (6) performance review.
Project appraisal involves six broad steps: (a) forecast the costs and benefits (b) Apply suitable investment criteria (c) Assess the risk of the project. (d) Estimate the cost of capital, (e) Value the options (f) Consider the overall corporate perspective.
While measuring the costs and benefits of a capital expenditure proposal, bear in mind the following guidelines: (a) Focus on post tax cash flows. (b) Measure cash flows on an incremental basis.(c) Exclude financing costs. (d) Treat inflation consistently.
The cash flow stream of a project may be divided into three parts: (a) initial investments, (b) operating cash flows and (c) salvage value.
Several criteria have been proposed for project evaluation. The popular ones are: payback period, average rate of return, net present value, and internal rate of return.
The payback period is the length of time required to recover the initial cash outlay on the project. According to this criterion, a project is acceptable if its payback period is less than a certain specified period.
The average rate of return also called the accounting rate of return may be defined as:
Profit after tax/Book value of the investment
A project is acceptable if its average rate of return exceeds a certain cut off rate of return.
The net present value of a project is equal to the sum of the present values of all the cash flows (outflows and inflows) associated with the project. A project is acceptable if its net present value exceeds zero.
The benefits cost ratio, also referred to as profitability index, is defined as:
Present value of benefits / Present value of costs:
A project is acceptable if its benefit cost ratio exceeds one.
The internal rate of return of a project is the discount rate which makes its net present value equal to zero. A project is acceptable if its internal rate of return exceeds the cost of capital.
Capital investments are almost invariably subject to risk arising from variety of factors like competition, technological changes, shift in consumers preferences, and so on.
For measuring the risk of a project the commonly employed techniques are sensitivity analysis and breakeven analysis. For large complex projects, simulation analysis and decision true analysis also be used.
Sensitivity analysis seeks to answer questions like: What will happen to the liability of a project when some variable like stakes or investment or project life deviates from its expected value.
Break-even analysis focuses on the minimum quantity that must be sold to ensure that the project does not lose money.
The commonly used methods for risk adjustment are: adjusting the discount rate, adjusting the cash flows, and adjusting the payback period.
All capital has a cost though it is not uniform. It tends to vary one source of capital to another, from one firm to another, from one firm to another, and from one point in time to another.
The marginal cost of capital is the post tax return, the firm must earn on its proposed capital investments to satisfy the expectations of investors who provide funds to support such capital investments.
More often than not, a project has a payoff in the form of new investment opportunities that may possibly open up if the project is undertaken.
Valuing the options embedded in real life projects is difficult. Yet, if you identify the options and specify the circumstances under which they would be exercised you can make an informed estimate of their values.
The capital budget of a firm in order to be meaningful and viable, must satisfy several overall corporate considerations (1) It must be consistent with the long range strategic plans for the business, (2) It must be compatible with the resources of the firm, (3) It must be controllable (4) It must be endorsed by the executive management.
Financial institutions appraise a project from the marketing technical, financial, economic, and managerial angles.