Characteristics Characteristics of Capital Investment Decisions Investment- means any project for which the rm spends a certain amount and from which it (the rm) expects something in return. . Capital investment investment decisions usually re!uire re!uire relatively large commitments of of resources. ". #ost capital capital investment investment decisio decisions ns involve involve long-term long-term commitments. commitments. $. Capital investment investment decisions are more more di%cult di%cult to reverse reverse than than short-term short-term decisions.
&he capital investment investment process process . Identication of 'otential 'otential 'rojects'rojects- 'otential 'otential projects projects came from the the proposals proposals sumitted y the managers of the dierent divisions or departments of the company that will e evaluated y top management. ". *stimation of Costs and +enets , #anagers sumit their their proposals proposals accompanied accompanied y the estimates of expected costs that the rm would incur for the project as well as the expected revenues or cost savings that may e derived from the project. $. *valuated of 'roposed 'roposed 'rojects'rojects- 'roposals 'roposals are evaluated in the the light light of the organiational goals and policies. . Development of the the Capital Capital *xpenditure *xpenditure +udget +udget - Consists of all all capital capital investment project proposals that have een approved for the udget period. /. 0eevalu eevaluati ation on of 'ro 'rojec jects ts
Capital expenditure expenditure or investment projects can e generally classied as follows1 . 0eplacement 0eplacement , 2hen an existing existing capital investment investment item ecomes ecomes osolete osolete or or suers suers irreparale damage. ". Improvement , #anagement may consider the improvement improvement of a certain product product or process. $. *xpansion , Involves enlargement of facilities3 facilities3 setting up additional additional usiness usiness segment and invasion of new mar4ets. Dependent or contingent proposals , the acceptance of one proposal is dependent on the acceptance of one or more potentials. #utually exclusive projects , acceptance of one proposal will mean automatic rejection of another proposal.
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Capital investment factors . :et investment- net cost of investment is dened as the net out>ow of cash3 a commitment of cash3 or the sacrice of an in>ow of cash Costs or cash out>ows a. Initial cash outlay 'urchase price of an asset Incidental project-related costs . 2or4ing capital re!uirement c. #ar4et value of an existing3 currently idle asset • •
;avings or Cash In>ow a. &rade-in value of old asset . 'roceeds from sale of old asset to e disposed c. 6voidale cost of immediate repairs on old asset to e replaced In case of replacement projects3 the oo4 value of the asset to e replaced is not included in the computation of the net cost of investment ecause such oo4 value is a sun4 cost thus3 irrelevant. ?or decision ma4ing purposes1 . Includes all cash outlays necessary to carry out the project ". 2or4ing Capital or net current asset committed to the project is included $. Includes opportunity cost . @istorical or sun4 costs are excluded /. &he net proceeds or trade-in value of assets to e disposed are deducted from the purchase price of the new asset to e ac!uired A. Considers time value of money In nancial accounting #ust e in accordance with 966'. Distinctions etween capital and revenue expenditures must e considered. 2or4ing capital components have their own place in the alance sheet3 these are not capitalied as xed asset.
Illustrative example1 . &he management of :6D87'I& ?I&:*;; C*:&*0 is planning to replace an old slimming machine which was ac!uired / years ago at a cost of '$B3BBB. &he old machine has een depreciated to its salvage value of '3BBB. :adulpit has found a uyer who is willing to purchase the old slimming machine for 'A3BBB.
&he new machine will cost '/B3BBB. Incidental costs of installation3 freight and insurance will have to e incurred at a total cost of 'B3BBB. ;hould the company decide to retain the old slimming machine that must e upgraded and sujected to major repairs. &he estimated cost of this repairs expense amounts to '3BBB. &he income tax rate is $/. 0e!uired1 Compute the net cost of investment in the new machine for decision ma4ing purposes. 'urchase price of the new machine '/B3BBB 6dd incidental costs of installation3 freight and insurance B3BBB &otal costEcash out>ow AB3BBB 7ess savingsEcash in>ows1 'roceeds from the sale of old machine A3BBB 7ess tax on the gain on sale FBB /3$BB 'roceeds on sale3 net of tax 3BBB 6voidale cost of repairs on old machine "3BB 7ess income tax 6voidale cost of repairs3net of tax /3"BB B3/BB :et cost of investment G3/BB ". 6ssume that instead of selling the old machine for 'A3BBB3 :adulpit will sell it only for '$3BBB. @ow will this aect the computationH Cash in>owsEsavings1 'roceeds from the sale of old machine
'$3BBB
6dd tax savings due to loss on sale 'roceeds 7ess oo4 value
7oss on sale &ax rate
'roceeds from sale of old machine incl. tax savings due to loss on sale
$. 6ssume that instead of selling the old machine3 :adulpit will just trade it in with a new one. 6ssume that the dealer of the new machine will grant
a trade-in allowance of '/3BBB for the old asset. @ow will this aect the computationH
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6ccounting :et Income , refers to the net income expected to e earned from project eing evaluated. :et Cash ?low- It involves only the cash revenues3 costs3 and expenses
*xample1
'in4y Company plans to uy a new machine to increase its plantJs productive capacity. &he new machineJs estimated installed cost is '/B3BBB. It is expected to have no salvage value at the end of its useful life of / years. +ased on 'in4yJs projections3 the new machine can produce BB3BBB units of product per year. +ecause of the high demand for this product which the company sells at '/ each3 it is expected that all the units produced will e sold. 0elevant production3 selling and administrative costs related to the product amount to '$ each3 exclusive of depreciation. &he company pays income tax at the rate of $/ of taxale income. 0e!uired1 . 6ccounting net income from the new machine ". &he net cash in>ows from the project
;ales(BB3BBB units x '/) '/BB3BBB 7ess costs and expenses1 'roduction3selling and administrative costs including depreciation (BB3BBB x '$) De
$BB3BBB
