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‫ݷ‬ Capital expenditure decisions are some of
the most formidable that have to be made by
management.
a When decision made to invest in long-lived
assets, company usually committing itself to
operating those assets for some time,
a reversal of decision will probably mean selling
assets at a loss.
a decisions shape bed on which the company must
lie in the future,
a hus, investment decisions are mutually important to
shareholder, employee, consumer and economy as a whole.
a
hareholder interested since capital expenditure decisions
affect earning power and growth.
a mployee affected since investment may result in an
improvement in profits and productivity, from which he may
expect increased earnings.
a Consumer hopes to benefit from an increase in productivity
by an improvement in quality or reduction in price.
a he economy as a whole is affected by the total volume of
the investment, together with its timing and quality.
a We can consider the total investment in a company as a
series of projects or investment decisions.
a n the traditional accounting 
  , emphasis is placed
on vertical rectangle below which represents a cross-section
of projects during a  



a whereas, in capital expenditure decisions, concentration is on
ë
ëë
 projects such as A (etc.), which cover number of
years
  

 


"    




‫ݷ‬ ollowing diagram shows the pattern of cash 
and which may be involved in capital
expenditure decision.
a  
 to determine whether cash involved
in investment is justified by cash to be created over its
life.
a actors needing evaluating, and illustrated by above diagram
 initial cost of project;
2 phasing of expenditure over project;
3 estimated life of investment;
4 amount and timing of resulting income.
a of funds needed to acquire capital asset is called 'the
investment'.
a n case of renewal project (for example, replacement of an
existing asset), investment will not be Ú
of the asset, but
amount of funds needed to cover the
ë Úbetween cost of
new asset and trade-in or scrap value of old one.




# 
"   
‫ݷ‬ Capital expenditure decisions involve comparing the
two µstreams¶ of funds, and
‫ݷ‬ if returns 

investment is , a  

decision may be indicated.
‫ݷ‬ owever, the two streams flow at different times.
‫ݷ‬ n many projects, returns from initial investment outlay
are obtained over long period of time.
‫ݷ‬ Necessary to make some adjustment for this time
difference
a must wait for returns to occur and waiting implies uncertainty
due to inherent difficulty of long-term forecasting.
a waiting involves the sacrifice of present consumption or other
investment opportunities.
a adjustment for the time differential, taking into account both
uncertainty and sacrifice of alternative uses of funds, is known
as  .
a effect of discounting is to express the two streams of
investment and returns in 
  "
 equivalents.
a discount rate must be selected with care and represents a most
important management decision.
a discount rate is related to cost of capital to the company, and is
a often expressed as the required earnings rate.
a incidence of taxation has a significant effect on the timing of
the streams of investment and returns.
‫ݷ‬ f the equation results in a positive figure

 AL m $%&'
 '  (A  AX
CA
)

m  AL m $%&'
( $)  (A  AX L)
‫ݷ‬ Capital expenditure project appears successful.


  



   




‫ݷ‬ ·istinct dangers in concentrating too

heavily on evaluation aspects of budgeting
for capital expenditure projects.
‫ݷ‬ o place evaluation techniques in proper
perspective, main components of capital
expenditure management programme
should be looked at.
 „ 
 

 


‫ݷ‬ echnological change increases and product & process
life cycles become shorter --> more intense search for
new and more profitable activities
‫ݷ‬ Management organise to ensure have Ú
 flow of
investment opportunities for appraisal. nvolves
a market research, economic forecasting,
a cost estimating, profitability analysis, simulation.
‫ݷ‬ Management look into future;
try to measure
economic attractiveness.
‫ݷ‬ Accountant recognise assumptions and
identify intangibles
u r 
 

 
‫ݷ‬ arely only one way of carrying out a project, and
careful evaluation of alternatives essential.
‫ݷ‬ When considering, e.g., machinery to carry out
specified tasks, frequently are several new machines
performing satisfactorily,
‫ݷ‬ but each might involve different investment and
different flow of returns.
‫ݷ‬ ften existing machine need not be replaced this year,
‫ݷ‬ herefore, ë ë
of replacement needs considering.
‫ݷ‬
atisfactory decision must begin with considering best
alternatives.
Œ ·
  


‫ݷ‬ Costs and revenues relevant to capital expenditure
decision are those arising from decision to invest.
‫ݷ‬ mphasis is on future incremental cash flows and
not on traditional historical cost accumulation.
‫ݷ‬ Cash flows and not book values are important in the
long run assessment.
‫ݷ‬ nformation used for evaluation may, therefore, be

ë from that shown in ÚÚ  ë

  

£ „ 
  
 


‫ݷ‬ Next ·oes project offers satisfactory returns?
‫ݷ‬  ë ë  satisfactory rate of return ?
‫ݷ‬ irm's    is factor here.
‫ݷ‬ @  satisfactory projects in attractiveness order.
‫ݷ‬ @ ë
 measure benefits of projects, in a way to
compare them
‫ݷ‬ Management must exercise ˜

   before and 
evaluation stage, on issues of overall company strategy.
‫ݷ‬ hese factors may not all be included when computing
return on investment.
 * „  


‫ݷ‬ )

   *
‫ݷ‬ ·evelop procedures for authorisation of expenditure.
‫ݷ‬ hen, controls are needed to ensure expenditure conforms
to specification and is within authorisation amount.
‫ݷ‬ Periodic statements to assess progress and outstanding
commitments.
‫ݷ‬
tatements audited elps accuracy of future estimates,
and to apply benefits of experience to future projects
‫ݷ‬ ·evise procedures to cover disposal of assets when asset
market value exceeds future earnings value
%
 %

   
 
+,
‫ݷ‬
amantha owell (M.·.) been considering
problem of replacement of one of automatic
moulding machines, and has had some
discussions with John Marsh (Accountant).
‫ݷ‬ Apparently three possible alternatives
a) ri-od machine, nearly same as present
machine, and from same British
supplier;
b) Polidot machine from rance; and
c) American Plastidex machine.
a  Need Proper evaluation of alternatives
stimate 
 #for each
alternative.
a 

 
 ·one this with Jean Wilkins.
Produced following figures
„
   
 ! "! 
!
r  *# ---- ---- ----

( #*
.

  --- £--- Œ---
u u--- Œ--- Œ---
Œ Œ--- Œ--- Œ---
£ Œ--- --- Œ---
* Œ--- *-- u---
Σ-- *-- ---
*£-- u--- *---
a 

 
*
a igures are approximate, but are best estimates.
a *
a hree methods of evaluating capital expenditure
decisions
 m

/
2 '
0 




3 1 
 #
a Are weaknesses and strengths of various capital
expenditure decision methods.
 m%.%2
‫ݷ‬ *
‫ݷ‬ º ˜Úë to calculate time when
‫ݷ‬ Project cash  #equals  
  #.
‫ݷ‬ Method gives following results
‫ݷ‬    $ "

‫ݷ‬ m

/
+

, £3Œ Œ Œ3Œ
‫ݷ‬ 

 
*
‫ݷ‬ Method tells us when we will get our money back.

uggests we should invest in Machine B.
a 

 
*
a But we should also be interested in



on
capital employed.
a his method does not tell us the return we are making
after covering initial outlay
a *
a Also
a Another major weakness of payback method is that it
ignores the ë ë
of cash flows
u ' %1'1+%4' ( ,
%45' +%,
‫ݷ‬ *
‫ݷ‬ [ 
˜

@ @ calculates 

annual 
as percentage of original outlay
       "    

# # #


 + 

,*£-- u--- *---




 -- ŒŒ- !Œ-
( 


 ---- ---- ----
% 6 ŒŒ6 !Œ6
+ 


   ,


 
*
a nteresting, but now seems we should purchase Machine A,
a Machine A least favoured under Payback Method.
*
a nadjusted rate of return method also does not take into
account ë ë
of cash flows. Also, obvious dangers in
working on average basis of whole life of projects.


 
*
a s there method dealing with of cash flows?
a Also £,000 received at end of year  with Machine A given
same weight in second method as £,000 received at end of
year 6 with Machine C.
a Prefer money today rather than money tomorrow,
a Any sensible method of evaluating capital projects should
take this into account.
Π1(4' 1%75&48
*
‫ݷ‬ ·iscounted Cash low method covers satisfactorily

amantha's objections to first two methods.
‫ݷ‬ Basic problem we have immediate cash   # to
purchase machine, and future cash  #could arise.
‫ݷ‬
amantha prefers to calculate in 
  "
  she
wishes to express Ú
ë  
ë 
 
.
‫ݷ‬ £,000 receivable in one year¶s time is worth less than
£,000 receivable now,
‫ݷ‬ What is value of £,000 receivable in one year's time?


 
*
a ·epends upon

used,
a sing 0% rate of interest,
a £,000 receivable in one year¶s time is worth £909 now.
a he £909 could be invested at 0%, which would
represent a total of £,000 in one year¶s time.
a Confused by the  ë
of the machines under first two
methods.

)
 5


*
a We've got another breakdown on our hands with that old
machine.
  
   % 




+ ,
   )
  )
 %

u )
  )
 

Π)
 % )
 
 9

 sing a 0% discount rate, complete
following table representing present value of
£00 receivable at end of a number of years.
+m
  
, .%- :---
.% :-
.%u
.%Œ
.%£
2 valuate the capital expenditure decision, using
discounted cash flow method (·C).
u %

   
 
+u,
*
‫ݷ‬ 

 Ú Úë 
ë
Úë
ë

Ú ëë

Ú
 
ë
 ë .
‫ݷ‬ Worthwhile taking long look at problem because, once
committed resources, will not be easy to retract.
‫ݷ‬ Need to regard capital expenditure  ë
as a major
management problem. Company should organise to deal
with  ë

Ú  of expenditure.
‫ݷ‬ 1 
5 #+15,
‫ݷ‬ wo main ways of using 15 technique
‫ݷ‬ 
& and ü
r
  



.
 m $%&'
)741+ m$,
‫ݷ‬ equired 



is assumed, and

  "
 of a project is calculated by  
all future cash flows at this required earnings rate.
‫ݷ‬ f total of these  Ú

initial outflow, then project is
giving a  
  ë
 ë

.
‫ݷ‬ o compare two or more projects, accountant can
compute the 

   +m(,of each project by
‫ݷ‬ 
  "
 + m$, of


ëë

by NPV of


‫ݷ‬ Project with highest m( is preferred.
 

 m$


) %  7 (  % ) %  7 (   ) %  7 (  
 ë
Ú    
   
   
 
 % 7 @   
4 '  5& 4 8 ü ear 0 0 0 0 0 0
nitia l outla y 0 £ ---- ---- ---- ---- - -- - ----
 % 7 ( 5& 4 8  £0.909 ,000 909 4,0 00 3,636 3,000 2,727

2 0.826 2,000 ,652 3,0 00 2,478 3,000 2,478

3 0.75 3,000 2,253 3,0 00 2,253 3,000 2,253
4 0.683 3,000 2,049 ,0 00 683 3,000 2,049
5 0.62 3,000 ,863 5 00 30 2,000 ,242
6 0.564 3,400 ,98 5 00 282 ,000 564
*£-- - ££ u---  £u * -- - ŒŒ

m 4 5(  %  ( & (  . ( 1 
0,644 9,6 42 ,33

0,000 0,000 0,000
= - = - =  Œ
*
a Assuming a
9




of 0%, Machines A and
C would give a return greater than 0%.
a  Úë 
 
ë
  
'

 
 



a n comparing Machines A and C, 

   of C is
greater than 

   of A.
a  Úë  
 

'

 
and is one to
prefer.


 
*
a Possible to
 state the return from each project?
*
a his is the objective of the  or internal rate of return
(() method.
u .(&14(  %&%
45' +(,)741
‫ݷ‬ All cash flows from a project are
ë
Ú  

at a variety of discount rates
‫ݷ‬ ntil, by trial and error, the rate is found at which
‫ݷ‬ the 
  "
 






9
.
*
‫ݷ‬ e had calculated the  of each project as follows 

   $ "

ü
r u6 !6 *6

‫ݷ‬ his rate of return can be shown in the form

of a repayment statement from a bank or
building society, a form with which many
managers are familiar.
m%.) %) ;)%7( 
.

"    (
 
 #
  






*6 
"   
# # # #
 ---- *-- Œ--- *--
u !*-- u * Œ---  u*
Œ  * - Œ--- !£
£ £   Œ--- uu!
* u*- Œ u---  u£
!! £
--- ! !
*--- *--- ----


 
*
a t might not be possible to re-invest the earnings from Machine
C at 5%?
*
a his is a problem. Also, not always one unique rate of return.
a         
  ˜Ú.
a Also the difficulty in estimating the life of the project
a he s would also have been different if we had assumed a
seven-year life instead of a six-year life for the machine.
a n m$ , an obvious difficulty lies in deciding what
ë 
should be used for
ë
Ú  ë
.
a
hould minimum required earnings rate be  ë
rate or the

ë
rate?
a Allowance needed for ë
in which receipts are received
money received in (say) third year of a project may be worth
more, due to a shortage of cash, than an equivalent amount of
money received in the second year.
*
a ·espite these problems, there is real benefit in
evaluating the project on a 1 
5 #
basis.
a Now need to demonstrate the significant effects of
taxation on investment decisions,
a We need to rework the examples on an after-tax basis.
a owever, not today«

 9
*
 Compare Net Present Value Method with üield
Method, considering their application to differing
projects with differing capital sums to be invested
2 What should be the minimum required earnings rate
of projects for the company?
 %<  =

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