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Capital investment decisions does not governed by one or more factors, because investment problem is not simply one of replacing old equipment by new one, but concerned with replacing an existing process in system with another process which makes entire system more effective. We discuss below some of relevant factors that affects investment decisions:
Management Outlook:- lf management is progressive and has aggressively marketing and growth outlook, it will encourage the innovation and favor capital proposals which ensure better productivity on quality or both. In some industries where product being manufactured is a simple standardized one, innovation is difficult and the management would be extremely cost conscious. In the contrast, in industries such as the chemicals and the electronics, a firm can not survive, if it follows the policy of 'make do' with the existing equipment. The management has to progressive and innovation must be encouraged in such cases.
(ii) Competitor's Strategy:- Competitors' strategy regarding the capital investment significant influence on the investment decision of company. If the competitors continue to install more equipment and succeed to turning out better products, the existence of company not following suit would seriously threatened. This reaction a rival's policy regarding capital investment often forces decision on the company'
(iii) Opportunities created by technological change:- Technological changes create equipment which may represent a major change in process, so that there emerges need for re evaluation of existing capital equipment in company. Some changes justify new investments. Sometimes old equipment which has to be replaced by new equipment as result of technical innovation may downgraded to some other applications, A proper evaluation of the aspect is necessary, but is not given due consideration. In this connection, we may that the cost of the new equipment is a major factor in investment decisions. However management should think in terms of incremental cost, not full accounting cost of the new equipment, because cost of new equipment is partly offset by salvage value of the replaced equipment. In a such analysis an index called the disposal ratio becomes the relevant.
(iv) Market forecast:- Both short and long run the market forecasts are influential factors in the capital investment decisions. In order to participate in the long run forecast for the market potential critical decisions on capital investment have to taken.
(v) Fiscal Incentives:- Tax concessions either on the new investment incomes or investment allowance allowed on the new investment decisions, method for allowing depreciation deduction allowance influence new investment decisions.
(vi) Cash flow Budget:- The analysis of the cash flow budget which shows the flow of funds into and out of the company may the affect capital investment decision in two ways. First, the analysis indicate that the company may acquire necessary cash to purchase equipment not immediately but after say, one year or it may show that purchase of capital assets now may generate the demand for major capital additions after years and such expenditure might be clash with anticipated other expenditures which can not be postponed. Secondly, cash flow budget shows the timing of the cash flows for a alternative investments and thus helps management in selecting desired investment project.
(vii) Non-economic factors:- New equipment may be make the workshop the pleasant place and permit more socializing on job. The effect would be reduced absenteeism and to increased productivity. It may be the difficult to evaluate benefits in monetary terms and as such we call it as non economic factor. Lets take one more example. Suppose installation of a new machine to ensures greater safety in the operation. It is difficult measure the resulting monetary saving through avoidance of the unknown number of injuries. Even then these factors give tangible results do the influence investment decisions.
Capital Investment Appraisal
Different methods of the capital investment appraisal available organisations and the clearly show when method would used, if at all the illustrating your answer with relevant examples.
Capital investment appraisal can described as the decision making process used by a organisations to evaluate the different investments and to decide which fixed assets purchase. In the following, four different methods of investment appraisal shall be discussed (ARR)accounting rate of return, payback period, (NPV)net present value and(IRR) internal rate of return.
The ARR expresses return on the investment as an annual percentage of the cost of that the investment. To decide to accept or reject the project, organisations can set the minimum ARR which needs be exceeded by the project's ARR. The advantages of ARR are that it is easy to understand and calculate, therefore accepted by many.
The ARR is only method that uses the profits instead of cash flows. Profit figure, however, can be influenced by very subjective estimates such as depreciation and stock valuation. Therefore, the ARR tends go to be less reliable than cash flow based methods. Another limitation of ARR is that it ignores the time value of money.
Although the ARR has some shortcomings, it can still be used as an initial evaluation of project as it is very easy to use method. However it should not be used as only method of investment appraisal as it provide the wrong results.
The payback period calculates how it will take to recover initial cash outflow of the investment. Organisations can set the target payback period or compare payback periods. By choosing investment with the shortest payback period, risk is minimise.
The limitations of the method are that is based on unrealistic assumption that cash flows evenly throughout year. Moreover, it does not consider the cash flows occurring after payback period.
Capital investment appraisal relevant cash flow:-
Making capital investment decision, the investment appraisal process need to take account of effects of taxation and inflation project cash flows and on required rate return since influence of these factors is inescapable. Expected future cash flows are subject both risk and uncertainty. In this chapter we consider some of the suggested mehods for the investment appraisal process to them into account. We look at what research has say about the way which investment appraisal is in real world.
To be consistent with wealth maximization principle, an evaluation of a project must be based on cash flows and not on accounting profits
To be able to use NPV technique or any other technique of capital budgeting analysis successfully and accurately, we must have
an unbiased estimate of the expected future cash flows of the project
including time to completion and estimate initial investment/cost
extremely important and most difficult task
APPORTIONED FIXED COSTS:-
Costs which will incurred regardless of whether a project undertaken or not, such as apportioned costs e.g. rent and building insurance or apportioned head office charges are not relevant to project evaluation and should be excluded. Only incremental costs which arise as a result of taking a project should be included as cash flows.
Opportunity cost is the benefit forgone using a asset for one purpose rather than another. If asset used for an investment to ask what benefit has been lost since this benefit opportunity cost is the relevant cost as far as the project is concerned. An example raw materials will serve to illustrate this point.
INCREMENTAL WORKING CAPITAL
Activity levels rise as result investment in fixed assets the companies levels of debtors stock of raw materials and stocks of finished goods also increase. These increase will be finance in part increases in trade creditors.
Financial accounting capital expenditure appears in the profit and loss accout ther form of annual depreciation charges. These charges are determined company management accordance relevant accounting standards. For taxation, capital expenditure is written off against taxable profits a manner laid down. Under this system companies write off expenditure by means of annual capital allowances.
Capital allowances are a matter of government policy.
TAX ALLOWABLE COST:-
Tax liabilities will arise on the taxable profits generated by a investment project. Liability to taxation is reduced to taxation is reduced by deducting allowable expenditure given by revenue when calculating taxable profit. Relief for capital is given by deducting capital allowances from annual revenue. When calculating taxable profit. Relief for capital expenditure is by deducting capital allowance from revenue.
A cost that has already been incurred and cannot be removed,and therefore should not be considered in an investment decision Costs incurred prior the start of investment project are called sunk costs and not relevant to project appraisal, even if they have not yet been paid, since such costs will be incurred of whether project is undertaken or not. Examples such costs are market research, historical cost of machinery owned, adn research development expenditure.
A cost that has already been incurred and cannot be recovered irrespective of the decision to accept or reject the project.
R&D, Market Research, Consultant's Fees
Financial Manager have concern to project for its cash relevency, and he alwasy concious about cash not to the success or other result, but for gurantee and more return of the cash. So to eveluate these things there are some method which are adopted by the managerto check the movement of cash in particular project.These method are as below.........
What DoesÂ Net Present Value - NPVÂ Mean?
The difference between the present value of cash inflows and the present value of cash outflows. NPV is used in capitalÂ budgetingÂ to analyze the profitability of an investment or project.Â
NPVÂ analysis is sensitive to theÂ reliability of future cash inflows that an investment or project will yield.Â Â
Net Present Value (NPV)
A net present value (NPV) includes all cash flows including initial cash flows such as the cost of purchasing an asset, whereas a present value does not. The simple present value is useful where the negative cash flow is an initial one-off.
With the NPV method, the advantage is that it is a direct measure of the dollar contribution to the stockholders.
consider the time value ofÂ money
-consider risk of future cash flow
-consider all cash flows
With the NPV method, is that the project size is not measured.
do not account the intangible benefis
do notÂ considerÂ for flexibility/uncertainty
Accounting rate of return
The accounting rate of return (ARR) is a way of comparing the profits you expect to make from an investment to the amount you need to invest.
method of estimating theÂ rate of returnÂ from an investment using a straight-line approach (not discounted or compounded). The investment inflows are totaled and the investment costs subtracted to derive the profit.
The ARR is normally calculated as the average annual profit you expect over the life of an investment project, compared with the average amount of capital invested. For example, if a project requires an average investment of £100,000 and is expected to produce an average annual profit of £15,000, the ARR would be 15 per cent.
Advantages of using ARR
â€¢ It is simple to calculate using accounting data
â€¢ Earning of each year is included in the calculating the profitability of the project
Unlike other methods of investment appraisal, the ARR is based on profits rather than cashflow. So it is affected by subjective, non-cash items such as the rate of depreciation you use to calculate profits.
It is inconsistency with wealth maximization as the objective of the firm
â€¢ Since it uses the accounting data it includes the amount of accruals in calculating the earnings "net profit".Â
â€¢ It is based on the familiar accrual accounting.
Internal Rate Of Return - IRRÂ Mean?
TheÂ discount rate often used in capital budgeting that makes the net present value of allÂ cash flowsÂ from a particular projectÂ equal to zero. Generally speaking, the higher a project's internal rate of return, the more desirable it is to undertake the project.
With the IRR method, the advantage is that it shows the return on the originalÂ moneyÂ invested.
With the IRR method, the disadvantage is that, at times, it can give you conflicting answers when compared to NPV for mutually exclusive projects. The 'multiple IRR problem' can also be an issue, as discussed below.
Payback PeriodÂ Mean?
The length of time required to recover the cost of an investment.
It will give you exact period to pay back Loan or financing, Difference between Cash inflows and Outflows are also outlined,Â
It is not for very long financing, It doesn't deal with Time value of money so many times companies have to pay more than they actually acquire,