Managerial Accounting - Capital Exepnditure Decisions
Technological advancements are forcing companies to scapped their old and obsolete assets and replace them with more efficient ones. Average machines life has reduced to 5-7 years. But this pays off as the new machines are cheaper to buy and more productive thereby recouping their cost in much lessor times than before. This fits into definition of technology which hovers around 'cheapest, quickest and easiest'.
In a capital expediture decision, a most important factor is size. The degree of risk is closely linked with the magnitude of the investment.
Capital Expanditure (Capex)
The term Capital Expenditure means long term investment in fixed assets. In turn, fixed assets mean property, plant and equipment (PP&E). These are to be used for further production and are not for sale. Whether a particular assets can be classified as fixed or current depends upon nature of the business. A power generator for a sugar plant would be a fixed asset whereas the same generator for the machinery supplier would be a part of stock and therefore a current asset.
What is a capital expenditure?
It is an expenditure with the aim of getting benefits in future. It applies not only to invesment in fixed assets but to related cost such as payment of custom duties, clearance and forwarding, erection and installation, markup during construction and trial runs.
Capital expenditures are incurred to setup greenfield project or to upgrade brownfield projects. It also cover Trophy projects which just boost image of the company. The manufacturers are paying due attention to their social responsibilities and are investing in such projects which reduce polution, increase safety within the factory and improve quality of life in the neighborhood through opening schools, hospital and recration facilities.
Type of Finances
Like type of projects, there are type of finances. Most common is commercial finance. The financier, usually a commercial bank, insists on security or collateral before hand. The bank either takes the security in its possession like shares, bonds & inventories or creates a charge over the assets. Once this is done, there is hardly any need for loan supervision.
Project finance differs from commercial finance. It is not based on security but on cash flow of the project. That is why a feasibility of the project is carried before any finance could be extended. The bank has a charge over the project's assets but these are all custom made and have very low market value. Therefore, the banks make certain that the project is viable. Even after disbursement of funds, the bank keeps an eye on the project through its system of surveillance.
Development finance is an off-shoot of project finance. It is concessionary and available only for priority sectors and also only for fixed capital investment. (Commercial finance is mostly used for raising current assets).
A simple example of two proposals
Mr. Kabeer desires to go for manufacturing. He has about Rs.15 million. Presently, he is concentrating on two projects: (i) Weaving mills & (ii) Oil Plant. Both projects require equal investment of Rs.10 million each and would generate an income as detailed in the table. Both projects have a four-year life with no salvage value at the end.
No other information is available except that the owner wants a return of at least 12% per annum. If so, which project should be selected.
DISCOUNTED CASH FLOWS
Calculating NPV at desired rate
For calculation of NPV, there are a number of steps to be taken as given below:
- Workout Operating Cash flow which, in simple terms, is adding back depreciation and markup in the net profit.
- Place total investments in year 0 which marks end of the construction year.
- Show year-wise income against respective years.
- Like in 3, write down discount rate applicable to each year at the desired discount rate which in our example is 12%.
- Findout discounted values and added them up. This would be Present Value.
- Deduct from this investment in year 0 and you will find NPV.
Necessary calculations are given in the side table. The weaving project would be rejected as NPV <1. The oil plant would be accepted as NPV >1.
Tools for taking Capital Decisions
Capital expenditure decisions are becoming frequent rather than rare. This hub examines ways and means to assess soundness or wisdom of such decisions through testing them with various tools which are both financial and non-financial.
The eventual aim could be sustainability or expansion which ever is the need of the time. For sustainability, one makes up the shortfalls in the plant or merely replaces the old equipment or modernizes the plant through installing better technology.
DETERMINATION OF DISCOUNT RATES
Choice of discount rate depends upon a number of factors. Generally, Cost of funds (Average Weighted Cost of Capital - AWCC) is used. If NPV= AWCC, at least we have covered our cost which includes dividends to share holders.
Other bench marks are : opportunity cost, group hurdle rates or a rate advised by planning commission of a country.
INDEPENDENT OR MUTUALLY EXCLUSIVE PROJECTS
Some times, an investors has restricted funds enough for one project. In this case, all eligible projects would be ranked and one with the highest NPV or IRR would be chosen. If the same investor has unlimited funds, all projects meeting criteria would be selected.
So mutually exclusive projects are those where acceptance of one eliminates consideration of others. While independent projects have no such conditions.
WEIGHTED AVERAGE COST OF CAPITAL
Funds from a project come from a variety of sources such as Shareholders contribution, loans from local and foreign banks. Except share-holder funds, there are tax consideration for others. The amount obtained would be weight assigned while rate would be after tax rate. Taking these two factors into consideration, we arrive at a WACC.
In Capital Expenditure Decisions, a long term view is taken into consideration. While investment would be made now, the revenue would accrue in future. Since a rupee now is better than a rupee in the next year, we use discounted techniques to find out present value of future cash flows.
At times, payback period is a strong stimulus for taking a decision for capital expenditure. When environments are uncertain or there is a law and order situation, an investor would attach more weight to payback period rather than IRR or NPV.
For development banks or governmental organization, economic factors are considered such as forex earning, regional development and alleviation of poverty..