Capital Investment | My Assignment Tutor

LO3: Week 5Capital Investment• Several companies spend money from time to time for fixed assets• Spending money on fixed assets is called capital expenditureReasons for capital expenditure• Maintenance: Spending on new fixed assets to replace worn-outassets or out-dated assets of spending on existing assets to improvesafety• Profitability: Spending on fixed assets to improve profitability ofexisting business to achieve cost savings quality improvement.Improved productivity• Expansion: Spending to expand a business, make new products,open new outlets, invest in resarch and developmentLO3 Week 5Reasons for capital expenditure Cont.Capital Budget• Indirect: Spending on fixed assets that will not have a direct impact on thebusiness operations or its profits e.g., spending on office building, welfarefacilities•Capital Budget• A program of capital expenditure for the next few years, updated everyyear which set out the followings• Authorized capital investment but not yet undertaken• Project that are likely to occur in next few years, but not yet authorizedCapital Budget• Before investment project goes ahead, it should be authorized by an appropriatemanager• Stages in capital budgeting circle in large organization includes• The requirements for capital expenditure in the business are forecast• Project that meet those requirements are identified• Alternative project for meeting the requirements are appraised• The best alternatives are selected and approved• When a project as been approved the capital expenditure is made• Actual spending is compared to planned spending and actual benefit obtainedare monitoredMethods of Capital Expenditure Appraisal•When forecast of costs and benefits have been made for acapital project•The business must analyzed to establish whether the projectshould go ahead•Should the business spend money now in order to earn returnover a number of years into the futureCapital Investment Appraisal• This is an analysis of the expected financial returns from a capital project over itsexpected lifeThere are several methods of carrying out capital expenditure appraisal• Return on capital employed (ROCE)• Payback Period• The net present value (NPV)• The internal rate of return (IRR)Return on Capital Employed (ROCE)• This may also be called accounting rate of return (ARR) which expresses the profitfrom the project as a percentage of capital cost• Formula:• ROCE: Average annual (post depreciation) profit before interest ad tax x 100• Initial capital costClass Illustration• A project involves the immediate purchase of an item of plant costing 110,000. Itwould generate annual cash flows of 24,400 for five years, starting in year 1. Theplant purchase would have a scrap value of 10,000 in five years when the projectterminates. Depreciation is on straight line basis• Solution: Annual cash flows are taken to be profit before depreciation• Average Annual depreciation: Cost-scrap/no of years• Average Annual depreciation: 110,000-10,000/5• Average Annual depreciation: 100,000/5• Average Annual depreciation: 20,000Illustration Cont.Average annual profit: 24,400-20,000Average annual profit : 4,400ROCE: Average Annual Profit x 100Initial Capital CostROCE: 4,400 X 100110,00ROCE: 4%Quick CheckClass Activity• A project involves the immediate purchase of an item of plant costing 400,000 Itwould generate annual cash flows of 84,200 for six years, starting in year 1. The plantpurchase would have a scrap value of 50,000 in six years when the projectterminates. Depreciation is on straight line basisMerits and Demerits of ROCEMerits• It is easily understood and easily calculated• Since it is assess a business, investment decisions made by business is a widely usedmeasure expressed in percentageDemerits• It fails to take account of the profit life• It might ignore working capital requirements• The decision to invest or not remains subjectivePay back Period (PBP)• This is a time which the project will take to pay back the initial money or capitalinvested in the project• It is based on expected cash flows not accounting profitPay back period is appraised in one of the waysA business may establish a rule for capital spending that no project should beundertaken unless it is expected to pay back within a given time periodWhen no alternative capital project are being compared and the decision is toundertake one or the other but not both. Preference might be given to the projectthat is expected to pay back soonerCalculating Pay back Period (Constant annual Cashflows)• If the expected cash inflows from a project are an equal annual amount, thepayback is calculated as follows• PBP = Initial Cost• Constant Annual Cash InflowsIllustration• An expenditure of 2,000,000 is expected to generate cash inflows of 500,000each year for the next seven years• What is the pay back period• Solution• Pay back Period = Initial cost• Annual Cash Inflows• PBP= 2000,0000• 500,000• PBP = 4 yearsQuick CheckClass Activity• An expenditure of 10,000,000 is expected to generate cash inflows of 900,000 eachyear for the next nine years• What is the pay back periodPay Back Period(Uneven cash flows)• Annual cash flows for a project are unlikely to be a constant annual amount, butare likely to vary from year to year• PBP is calculated by finding out when the cumulative cash inflows from the projectwill pay back the money spent• Cumulative cash inflows should be worked out by adding each year cash flows ona cumulative basis, to net cash flow to date for the projectIllustration• A Project is expected to have the following cash flows• Year Cash flows• 0 (2,000)• 1 500• 2 500• 3 400• 4 600• 5 300• 6 200• What is the expected payback period?Solution Pay back Period• Year Cash Flows Pay Back Period PBP• 0 (2,000) (2,000) (2,000)• 1 500 500 (1,500)• 2 500 1,000 (1,000)• 3 400 1,400 (600)• 4 600 2,000 0• 5 300• 6 200• The pay back period is 4 yearsQuick CheckClass Activity• A Project is expected to have the following cash flows• Year Cash Flows• 0 (1,900)• 1 300• 2 500• 3 600• 4 800• 5 500Merits and demerit of Pay back PeriodMerits• It is easily understood and easily calculated• It uses cash flows rather than profitDemerits• Cash flows after payback period may be ignored• No objective measure as to the length of time for pay back periodClass Activity• ABC is investing in two mutually exclusive projects X and Y. The cost of theproject and the cash inflows are as follows• Project X Project Y• Cost of Project( 65,000) ( 70,000)• : 1 15,000 10,000• 2 14,000 11,000• 3 15,000 20,000• 4 19,000 20,000• 5 5,000 19,000• 6 10,000 15,000

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