Capital expenditures (CAPEX) are funds used by a company to acquire or upgrade physical assets like equipment, property, or buildings to generate future benefits. CAPEX is evaluated using capital budgeting techniques like net present value (NPV) analysis, which discounts future cash flows to determine if a project's value exceeds its cost. The capital expenditure process involves generating investment proposals, evaluating proposals using methods like NPV, approving projects, and conducting post-completion audits to review project performance.

1. Capital Expenditure
Control

2. Capital Expenditure
 Capital expenditures (CAPEX or capex) are expenditures creating
future benefits. A capital expenditure is incurred when a business
spends money either to buy fixed assets or to add to the value of an
existing fixed asset.
 CAPEX are used by a company
to acquire or upgrade physical assets such as equipment, property, or
industrial buildings.
 CAPEX is commonly found on the cash flow statement under
"Investment in Plant, Property, and Equipment"

3. Capital Expenditure
• Included in capital expenditures are amounts spent on:
1. acquiring fixed, and in some cases, intangible assets
2. repairing an existing asset so as to improve its useful life
3. upgrading an existing asset if it results in a superior fixture
4. preparing an asset to be used in business
5. restoring asset or adapting it to a new or different use
6. starting or acquiring a new business
For Capital Expenditure you require Capital Budgeting as a
strategic planning Process

4. Capital Budgeting
• A truck manufacturer want a investment in new plant
• Pharmaceutical company is evaluating major R&D program
• Air India is planning to purchase fleet of Boeing Dream-liner 350.
• NHDAI planning to Pune-Nashik 6-lane highways
All these situations involve capital expenditure decision.

5. Capital Budgeting
• Capital budget:
• The capital budget relates to the question of capacity and
strategic direction of the firm. It deals with the evaluation of
the alternate disposition of capital funds as well as the
choice of the best capital structure.
• The basic characteristic of a capital expenditure (also referred as
capital investment or capital project or just project) is that it typically
involves a current outlay or current & future outlays of fund in the
expectation of a stream of benefits extending far into future.
• Capital expenditure represents the growing edge of business.

6. Capital Budgeting
• How firm finances its investments (the capital structure decision) and
how it manages its short-term operations (the working capital
decisions) are definitely issues of concern but how it allocates its
capital (the capital budgeting decisions) really reflects its strategy and
its business.
• That is why capital budgeting also referred as strategic asset
allocations.

7. Capital Budgeting Process
• Capital Budgeting is a complex process which divided into following
phases;
• Identification of potential investment opportunities.
• Assembling of proposed investments
• Decision making
• Preparation of capital budget and appropriations
• Implementation
• Performance review

8. THE CAPITAL BUDGETING PROCESS
• GENERATE PROJECT PROPOSALS
• ESTIMATE CASH FLOWS
• EVALUATE ALTERNATIVES
• SELECT PROJECTS

9. TYPES OF CAPITAL EXPENDITURES
• PURCHASE NEW EQUIPMENT
• REPLACE EXISTING ASSETS
• INVESTMENTS IN WORKING CAPITAL
• MERGER AND ACQUISITION ANALYSIS

10. Investment Criteria
• To judge worth-whileness of investment
projects following criteria suggested
• Discounting Criteria
• Net Present Value-NPV
• Benefit Cost Ratio-BCR (Profitability-Index)
• Internal Rate of Return-IRR
• Non-Discounting Criteria
• Payback period-PB
• Accounting rate of return-ARR

11. Net Present Value-NPV
• The net present value (NPV) of a project is the sum of present
values of all cash flows (positive as well as negative) that are
expected to occur over the life of the project.
• Where;
NPV= Net Present value
CFt = Cash flow at the end of year t
n=is the life of the project
r=is the discount rate
CF0= Initial Investment
 
.
1
0
1
CF
r
CF
NPV t
t
n
t


 

12. Decision Rule for-NPV
• The NPV presents the net benefit over and above the
compensation for time and risk.
• Hence decision rule associated with the NPV criterion is;
• Accept the project if the NPV is positive and
• Reject the project if NPV is negative.
• If the NPV=0; it is a matter of indifference. (accept or reject)

13. NPV- Properties of the NPV
Rule
• NPV are additive:
• The value of the firm can be expressed as the sum of the present
value of project in place as well as the net present value of
prospective projects.
• When a firm terminates an existing project which has negative
NPV based on expected future cash flows, the value of the firm
increases by that amount.
• When a firm undertake a new project that has a negative NPV,
the value of firm decreases by that amount.

14. NPV- Properties of the NPV
Rule
• When firm makes an acquisitions and pays a price in excess of
present value of the expected cash flows from the acquisitions it
is like taking on a negative NPV project and hence will diminish
the value of the firm.
• When a firm takes on new project with positive NPV, its effect on
the value of the firm depends on whether its NPV is in line with
expectations.

15. NPV- Properties of the NPV
Rule
• Intermediate Cash Flows are invested at the Cost of Capital.
• The NPV rule assumes that the intermediate cash flow of the
project-that is, cash flows that occurs between the initiation and
termination of the project-are reinvested at a rate of return equal
to the cost of capital.
• NPV calculations permits time varying discount rates
• We assumes that the discount rate remains constant over time-
this need not be always the case.
• The NPV can be calculated using time-varying discount rates

16. Limitations of NPV
• The NPV is expressed in absolute terms rather than relative
terms and hence does not factor in the scale of investment.
(A-NPV 5000-Investment 50,000, B-NPV-2500-Investment
15,000)
• The NPV rule does not consider the life of the project. Hence,
when mutually exclusive projects with different lives are being
considered, the NPV rule is biased in favour of the longer term
project.

17. Net-Present-Value Method
Annual net cash inflows from operations
Sales revenue 750,000$
Cost of parts sold 400,000
Gross margin 350,000
Less out-of-pocket costs 270,000
Annual net cash inflows 80,000$

18. Net-Present-Value Method
Years
Cash
Flows
10%
Factor
Present
Value
Investment in equipment Now $(160,000) 1.000 (160,000)$
Working capital needed Now (100,000) 1.000 (100,000)
Annual net cash inflows 1-5 80,000 3.791 303,280
Relining of equipment 3 (30,000) 0.751 (22,530)
Salvage value of equip. 5 5,000 0.621 3,105
Working capital released 5 100,000 0.621 62,100
Net present value 85,955$
Mattson should accept the contract because the present
value of the cash inflows exceeds the present value of the
cash outflows by $85,955. The project has a positive net
present value.

19. Benefit Cost Ratio-Profitability Index
Where:
PVB= Present value of benefits
I= Initial Investment
Benefit Cost Ratio
BCR= PVB/I
Net Benefit Cost Ratio
NBCR= BCR-1

20. BCR-Decision Rule
• When
BCR or NBCR rule is
>1 >0 accept
=1 =0 Indifferent
<1 <0 reject

21. Internal Rate of Return-IRR
• The internal rate of return-IRR of a project is the discount rate which
makes its NPV equal to zero.
• It is the discount rate which equates the present value of future cash
flows with the initial investments.
Investments = =CF0
• Where;
CFt= Cash flow at the end of the year t,
IRR=Internal rate of return
n=life of the project
n
t=1
CFt
(1+IRR) t

22. Internal Rate of Return (IRR)
IRR is the discount rate that equates the
present value of the future net cash flows
from an investment project with the
project’s initial cash outflow.
CF1 CF2 CFn
(1+IRR)1 (1+IRR)2 (1+IRR)n
+ . . . ++ICO =

23. Discount Rate (%)
0 3 6 9 12 15
IRR
NPV@13%
Sum of CF’s Plot NPV for each
discount rate.
NetPresentValue
Rs. ‘000s
15
10
5
0
-4
Net Present Value Profile

24. r > IRR
and NPV < 0.
Reject.
NPV (Rs.)
r (%)
IRR
IRR > r
and NPV > 0
Accept.
NPV and IRR always lead to the same accept/reject decision for
independent projects:

25. Problems with IRR
• There are problems in using IRR when cash flows of the
project are not conventional or when two or more projects are
being compared to determine which one is the best.
• In the first case it is difficult to define ‘what is IRR’ and in the
second case IRR can be misleading.
• Further, IRR cannot distinguish between lending and
borrowing.
• Finally, IRR is difficult to apply when short term interest rates
differ from long-term interest rates.

26. Choosing the Optimal Capital Budget
• Finance theory says to accept all
positive NPV projects.
• Two problems can occur when there is
not enough internally generated cash
to fund all positive NPV projects:
• An increasing marginal cost of capital.
• Capital rationing

27. Increasing Marginal Cost of Capital
• Externally raised capital can have large flotation costs, which
increase the cost of capital.
• Investors often perceive large capital budgets as being risky,
which drives up the cost of capital.
• If external funds will be raised, then the NPV of all projects
should be estimated using this higher marginal cost of capital.

28. Payback Period-PBP
• The payback period is the length of time required to
recover the initial cash outlay on the project.
• PBP is the period of time required for the cumulative
expected cash flows from an investment project to
equal the initial cash outflow.
• PBP The number of years required to recover a
project’s cost,
OR
• how long does it take to get the business’s money
back?

29. Payback Period (PBP)
• Payback Example:
0 1 2 3 4 5
-40 K 10 K 12 K 15 K 10 K 7 K
ICO Cash Flows (CF)

30. (c)10 K 22 K 37 K 47 K 54 K
Payback Solution (#
Method1)
PBP = a + ( b - c ) / d
= 3 + (40 - 37) / 10
= 3 + (3) / 10
= 3.3 Years
0 1 2 3 4 5
-40 K 10 K 12 K 15 K 10 K 7 K
Cumulative
Inflows
(a)
(-b) (d)

31. (c)-30 K -18 K -3 K 7 K 14 K
Payback Solution (#Method
2)
PBP = a + ( c ) / d
= 3 + ( 3 ) / 10
= 3.3 Years
0 1 2 3 4 5
-40 K 10 K 12 K 15 K 10 K 7 K
Cumulative
Cash flows
(a)
(-b) (d)

32. PBP
• According to PBP criterion, the shorter the payback period,
the more desirable the project.
• Firms using this criterion generally specify the maximum
acceptable payback period.
• If this is ‘n’ years, projects with a payback period of ‘n’ years
or less are deemed worthwhile and projects with a payback
period exceeding ‘n’ years are considered unworthy.

33. Advantages of PBP
• It is simple, both in concept and application. It does not use
involved concepts and tedious calculations and has few hidden
assumptions.
• It is rough and ready method for dealing with risk. It favours
projects which generate substantial cash inflows in earlier
years and discriminates against projects which brings
substantial cash inflows in later years but not in earlier years.
• Since it emphasizes earlier cash inflows, it may be sensible
criterion when the firm is pressed with the problem of
liquidity.

34. Limitations of PBP
• It fails to consider time value of money. Cash inflows, in
payback calculations, are simply added without suitable
discounting. This violets the most basic principles of Financial
analysis.
• It ignores cash flows beyond the payback period. This leads
discrimination against project which generate substantial cash
inflows in later years.
• It is a measure of project’s capital recovery, not profitability.
• Though it measures a project’s liquidity, it does not indicate
the liquidity position of the firm as a whole, which is more
important.

35. Accounting Rate of Return
• The accounting rate of return, also called the average rate of
return, is defined as
Profit after tax
Book value of the investment

36. Capital Expenditure Process
• The capital expenditure process involves:
• Generation of investment proposals.
• Evaluation and selection of those proposals.
• Approval and control of capital expenditures.
• Post-completion audit of investment projects.

37. Generation of Investment
Proposals
• Investment ideas can range from simple upgrades of
equipment, replacing existing inefficient equipment, through
to plant expansions, new product development or corporate
takeovers.
• Generation of good ideas for capital expenditure
is better facilitated if a systematic means of searching for and
developing them exists.
• This may be assisted by financial incentives
and bonuses for those who propose successful projects.

38. Evaluation and Selection of
Investment Proposals
• In order to evaluate a proposal, the following data should be
considered:
• Brief description of the proposal.
• Statement as to why it is desirable or necessary.
• Estimate of the amount and timing of the cash outlays.
• Estimate of the amount and timing of the cash inflows.
• Estimate of when the proposal will come into operation.
• Estimate of the proposal’s economic life.

39. Approval and Control of Capital
Expenditures
• Capital-expenditure budget (CEB) maps out the estimated
future capital expenditure on new and continuing projects.
• CEB has the important role of setting administrative
procedures to implement the project (project timetable,
procedures for controlling costs).
• Timing is important because project delays and
cost over-runs will lower the NPV of a project, costing
shareholder wealth.

40. Technical Performance Measures
• Represent critical technical thresholds and goals for success of
the program/ Project
• Should be variable and responsive to engineering changes
• Usually exist in a hierarchy corresponding to the spec. levels
(system, subsystem, component…)
• Have target values corresponding to specification values
• that is, your TPM should be a parameter in a spec at some level
• Are tracked and stat used against their defined plan and
represent the technical health of the program/ project

41. Typical Types of TPMs
• Parameters that flow from and/or support KPPs
• Key Constraints and Performance Reqmts
• Weight, power, heat load
• Reliability/ Maintenance parameters
• System / subsystem performance
• Endurance
• Range
• Latency
• Accuracy
• Efficiency
• Cost
• Parameters associated with Program Technical Risks or
areas of technical challenge
TPMs should represent a balanced set of key parameters;
Don’t monitor something just because “you can”

42. Post-completion Audit of
Investment Projects
• Highlights any cash flows that have deviated significantly from
the budget and provides explanations where possible.
• Benefits of conducting an audit:
• May improve quality of investment decisions.
• Provides information that will enable implementation of
improvements in the project’s operating performance.
• May result in the re-evaluation and possible abandonment of an
unsuccessful project.