CIMA knowledge fast forward
View(s):CIMA knowledge fast forward is a knowledge sharing initiative which strives to improve the conceptual clarity of the business community with regard to a core management/financial accounting or business related knowledge area, describing the concept, and explaining how it applies in practice.
Sharika Mubarack (ACMA, CGMA, LLCM, ATCL) counts over five years of experience in the Accounting field with added proficiency in Speech and Drama. She is an employee at Tangerine Group of Hotels and is currently pursuing a MBA from the University of Leicester UK.
Evaluating Capital Expenditure: Factors to consider
The importance of Capital Expenditure decisions to a company is not denied due to their enormous cost and irreversible nature. For instance, the group capital expenditure of Dialog Axiata for the year 2012 alone was 17.41 billion Rupees (Annual Report 2012). The prevailing economic conditions in the business world today, neck to neck competition and rapid changes in technology create added pressure for a company to make the most of its long term investments.
‘How to evaluate Capital Expenditures and other long term investments’ is a recent CGMA publication that provides an enlightening view on this area. The global study demonstrated that there is little difference in the financial evaluation between an acquisition and capital expenditure and investment.
The report aims to highlight the importance of budgeting in long term decision making, provides a comparison of the IRR and NPV methods and briefs on financing and hedging in relation to capital investment decisions.
Capital Budgeting
The study defines budgeting as a ‘disciplined process’ that allocates resources and establishes a broad plan to manage the resources of an organization. A cash budget is essential in capital budgeting to recognize unanticipated changes in working capital that can reduce the cash available for the project. It will also assist in taking proactive measures when cash imbalances are identified. One of the first steps in capital budgeting involves preparing a budgeted Profit and Loss Statement in cash form with actual timings.
The next step in the process would include shortlisting of proposed projects based on categories such as Replacement, Expansion, Productivity, Development or Mandatory requirements. Thereafter, the company needs to assure that the assumptions used to evaluate all the proposed projects are consistent. Subsequently, projects need to be tested for mutually exclusivity or dependence on each other and finally, the company needs to ensure that all relevant expenditure is identified for each project.
However, the report emphasizes certain key issues of evaluating a group of projects. First, the rate of required return varies with each project. Further, the returns will also vary based on the goal of the project. For instance, in the case of projects that are statutorily required or enforced for safety measures, returns are not the main focus whereas development projects will anticipate the highest return. Another key issue would be on the nature of the capital for each project, some projects may include fixed capital whereas the other would have flexible capital.
The study associates risk with project planning as it states that any failure in achieving short term results may prove detrimental to long term success. The Kelly Criterion risk management strategy is demonstrated in the global study to allocate investment funds and for selecting capital projects. This risk strategy creates boundaries for investing as results become known.
The benefit the budgeting process adds to capital projects is the ability to identify any alternatives to the proposed options. For instance, Eli Lilly initiated a lab to curtail the cost of developing new drugs which they successfully achieved.
Valuation – IRR vs. Present Value
The selection of a project is gauged based on the IRR of the project. If the IRR rate is equal to or surpasses the hurdle rate, the project is generally accepted. The IRR attempts to identify the discount rate that equates the present value of both the cash inflows and cash outflows. Present Value on the other hand unfolds the net present value of the future cash flows given a required rate of return. Thus, if the net present value is greater than zero the project can be accepted.
The similarity between both methods is that they are used as criteria to select or reject projects. However, the IRR is expressed as a percentage which is disadvantageous as it tends to ignore potential risk and can complicate the financial results causing the company to forego a larger project for a smaller one purely based on the return. The NPV is recognized as the more reliable measure.
Financing
This section of the study focuses on the importance on the method of financing. The cost of capital of a company varies directly with the size and predictability of cash flows. The more unstable the returns, the higher the rate of return demanded by the shareholders. The cost of capital is the weighted average of the after tax cost of debt with the cost of equity. Debt is the cheapest method of finance. The cost of debt is portrayed using the Historic interest rate curve where the curve has an upward slope. The short term rates are less than long term rates because higher inflation rates are anticipated in the future.
Hedging
As capital projects demand large sources of funds, hedging can help a company protect itself from volatile situations. For instance, a company can agree to buy or sell a certain commodity at a fixed price on a specified date. Hedging agreements are commonly used to mitigate risks in banks, for example, DFCC Sri Lanka uses hedging on foreign currency transactions (Annual Report 2012)
However, imperfect hedges can go wrong. For instance, J P Morgan lost $2 billion when its hedging strategy failed (www.forbes.com). Therefore, hedges need to be considered similar to insurance contracts from the perspective of a capital programme.
For a more in-depth look at making these decisions, CIMA Sri Lanka will be organizing a workshop on 19 June on ‘How to evaluate capital expenditure and other long term investments’ which will be conducted by Mr. Ravi Edirisinghe. For more information, please contact the Thought Leadership team on 0112503880.
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