This Slideshare presentation is a partial preview of the full business document. To view and download the full document, please go here: http://flevy.com/browse/business-document/capital-investment-analysis-230 Capital Investment Analysis Also called Capital Budgeting - a complex topic simplified in an easy to understand presentation which is completely self-explanatory. Explains the framework for financial analysis with examples and provides practical insights. Can be used for reference, training & self paced learning. The presentation includes examples worked in an Excel sheet. Covers: * The nature & characteristics of long term investments made by corporations * The problem associated with measuring the rate of return with long term investments * The approach to solving this problem * The key methods used in calculating the rate of return and evaluating alternatives * The practical aspects of the various inputs required to calculate the return on investment * The basics of the risks associated with long term investments & how to factor ?in such risks * The strategic considerations involved in long term investment decisions * The processes involved in long term investment decisions & its implementation

1. Capital Investment Analysis
Also called Capital Budgeting - a complex topic
simplified in an easy to understand presentation which
is completely self-explanatory. Explains the framework
for financial analysis with examples and provides
practical insights. Can be used for reference, training
& self paced learning. The presentation includes
examples worked in an Excel sheet.

2. What is Capital Budgeting (CB)?
The nature &
characteristics
of long term
investments
made by
corporations

3. Capital Budgeting?
Business
looking to
grow take
decisions on
• New products
• New Markets
• New production
facilities
• New technology
• Market share etc.
This involves
investment of
funds in
• R&D
• Capacity increase
• Buying new
technology
• Buying new
companies,
brands etc.
Such
investments
need to be
evaluated
because
• Large outlays
are involved
initially
• Returns come
by way of cash
flows in future
Capital budgeting is the process of
evaluation of specific investment (also
called capital expenditure) proposals.
‘Capital’ refers to the funds that needs
to be invested i.e. the assets to be
bought/created using the funds, which
in turn would contribute to the
growth/competitiveness.
‘Budgeting’ refers to the estimation of
the funds that may be required initially
and also the estimation of cash flows
that the assts so procured will generate
in the future.

4. CB – Importance
• Capital expenditure or Capex represents the
growing edge of a business and is also needed to
maintain competitiveness.
• Future profits & its growth depends upon the
return new capital investment generate and is
under the constant scrutiny of the market.
• The need for a business to earn a sufficient rate
of return on its investment (ROI) over and above
its cost of funds is well understood.
• One of the key responsibility of the management
is to ensure that all future capex also generate
adequate return to maintain and improve the
market standing of the firm.

5. Capital Budgeting – The Problem
The problem
associated with
measuring the
rate of return
with long term
investments

6. • In general whenever a capital investment is made
• there will be a large funds outflow during a
period
• followed by a stream of cash in flows as the
investment starts generating revenues
• The business hopes that the inflows will repay the
initial investment and also provide an adequate
surplus.
• The problem is how to relate the immediate cash
out-flow with a stream of future in-flows. Let us
address this issue….
CB – The Problem

7. CB – The Problem
Time
Period
Investment Return
0 Payment
Out
1 +
2 +
3 +
4 +
5 +
Time
Period
Investment B
($)
Return
($)
0 -1000
1 +200
2 +200
3 +200
4 +200
5 +1200
Total 2000
How do we compare a
future stream with a
present lump sum? How
to calculate the ROI?
Investment repayment is
done in one lump sum at
the end of the period
together with the last
interest payment
($1000+$200)
Fixed Income Security
patterns of returns,
interest, repayments
easily identified.

8. CB – The Problem
Time
Period
Investment Return
0 Payment
Out
1 +
2 +
3 +
4 +
5 +
Time
Period
Investment A
($)
Return
($)
0 -1000
1 +300
2 +400
3 +600
4 +500
5 +200
Total 2000
How do we compare a
future stream with a
present lump sum? How
to calculate the ROI?
In commercial investment
repayment is not done in
one lump sum at the end
of the period - it is spread
over a number of years.

9. • Also we all know that money received in a distant
time in the future is not worth the value of money
today.
• This concept is also popularly known as ‘Time
Value of Money’.
• Due to this we cannot compare sums of money or
cash flows that fall in different time periods.
• To compare we need a mechanism where all the
value of money/cash flows can be expressed at
one specific time period.
• The period selected usually is Period 0.
• Let us now understand how to do this.
CB – The Problem

10. CB – Approach
Time
Period
Investment Return
0 Payment
Out
1 +
2 +
3 +
4 +
5 +
Each item in the
stream of payments
is to be brought
back to today’s
value. These
separate amounts
when totaled to give
a single lump sum
that can be
compared with the
investment lump
sum.Total Return in today’s
money then can be
compared with the initial
investment made.

11. CB – Approach
Time
Period
Investment ($)
@10% P.A.
Future
Value (FV)
($)
0 100
1 100(1+10/100)1
= 100x1.1
110
A = P(1+r/100)n Future Value -
Principal + Interest
at the end of year 1
P= Principal (Amount Invested)
r = Interest rate per period
n = Number of years (or number of periods)
A = Amount at the end of the period n
This is the well known compound Interest formula which is taught
at the school level.
Thus FV at the end of
Period 2 = 100(1.1)2
Period 3 = 100(1.1)3
Period 4 = 100(1.1)4
Period 5 = 100(1.1)5

12. CB – Approach
Thus FV at the end of
Period 1 = 100(1.1) = 100 x 1.1
Period 2 = 100(1.1)2 = 100 x 1.210
Period 3 = 100(1.1)3 = 100 x 1.331
Period 4 = 100(1.1)4 = 100 x 1.464
Period 5 = 100(1.1)5 = 100 x 1.611……
Thus PV if investment and interest
realised at the end of
Period 1 = 100/(1.1) = 100x(0.909)
Period 2 = 100/(1.1)2 = 100x(0.826)
Period 3 = 100/(1.1)3 = 100x(0.751)
Period 4 = 100/(1.1)4 = 100x(0.683)
Period 5 = 100/(1.1)5 = 100x(0.621)……
Future Value or
Compounding
Interest Rate
Factors
Present Value or
Discounting
Interest Rate
Factors

13. Present Value
Time
Period
Investment
($)
Return
($)
PV
factor
@10%
PV
($)
0 5000
1 1500 0.909 1364
2 3500 0.826 2893
3 1400 0.751 1052
Total 5309
This is the
expected initial
outflow towards
the capital
investment in
time period 0
These are expected
value of cash inflows
at the end of
subsequent periods –
here period assumed
to be one year
These are the PV
factors which when
we multiply with the
cash inflow values we
get the PV of the cash
inflows.
Total PV of the
cash inflows
expected in the
future periods.

14. Net Present Value
Time
Period
Investment
($)
Return
($)
PV
factor
@10%
PV
($)
0 5000
1 1500 0.909 1364
2 3500 0.826 2893
3 1400 0.751 1052
Total 5309
We now
have two
numbers
that can
compared
directly
NPV = $5309 – $5000 = $309
The concept of Net Present Value is
introduced here which the difference
between the PV of the cash flows in
future periods and the cash flow today

15. Time
Period
Investment
($)
Return
($)
PV
factor
@10%
PV
($)
0 5309
1 1500 0.909 1364
2 3500 0.826 2893
3 1400 0.751 1052
Total 5309
This means
the cash
flows give
a return of
10% p.a.
exactly.
Therefore with an investment of less
than $5309 if we get the same cash
inflows, then the return must be
higher than 10% p.a.
Net Present Value

16. Ti
me
Per
iod
Investment
($)
Return
($)
PV
factor
@10%
PV
($)
0 5309
1 1500 0.909 1364
2 3500 0.826 2893
3 1400 0.751 1052
Total 5309
This means
the cash
flows give
a return of
10% p.a.
exactly.
Therefore with an investment of than
$5309 we get the same cash inflows
than the return must be higher than
10% p.a.
NPV = $5309 – $5000 = $309
NPV = $5309 – $5309 = 0
A positive NPV means that the project
is likely to deliver a rate of return
greater than the interest rate being
used in the calculations (the hurdle
rate) and vice versa.
ROI =10%
ROI >10%
Net Present Value

17. Time
Period
Investment
($)
Return
($)
PV
factor
@10%
PV
($)
0 5000
1 1500 0.909 1364
2 3500 0.826 2893
3 1400 0.751 1052
Total 5309
We know that
the return is
greater than
10%...but what
is the return?
For this let us
first determine
the PV of
future cash
flows at 11%.
Time
Period
Investment
($)
Return
($)
PV
factor
@11%
PV
($)
0 5000
1 1500 0.901 1351
2 3500 0.812 2841
3 1400 0.731 1024
Total 5216
Internal Rate of Return (IRR)

18. Interest
Rate %
PV ($) Investment
($)
NPV
($)
10 5309 5000 309
11 5216 5000 216
12 5126 5000 126
13 5039 5000 39
14 4954 5000 -46
15 4871 5000 -129
NPV would be 0
some where
between 13 & 14%.
??
This rate is the IRR of the project. The
project is selected for further evaluation if
IRR is equal to or greater than the hurdle
rate decided by the management.
We carry out this
exercise with
different
increasing rates.
Internal Rate of Return (IRR)

19. CB Inputs – The Practical Aspects
The practical
aspects of the
various inputs
required to
calculate the
return on
investment

20. • Capital Investment
• Consider only the incremental cash outlay i.e.
total additional cash flows that could result from
doing the project as against not doing it.
• Factor-in any savings arising from operational
synergies, tax etc.
• Include additional working capital (such as
inventories) that may be required to support the
investment.
• Do not include any allocated cost i.e. costs that
are transferred from other parts of the firm
which does not result in any additional cash
outflow.
CB Inputs – Practical Aspects

21. • Life of the Project
• This can be based on project’s physical,
technological or economic life span.
• Computers even if physical exist can be
outdated in two to three years.
• Similarly transport vehicles may exist physically
even after 5 years but cost of maintaining and
running them may not be economical etc.
• The estimated saleable value of the assets at
the end of the period is called the Terminal
Value and considered as a cash inflow in the
DCF model.
CB Inputs – Practical Aspects

22. • NPV and IRR are interrelated frameworks popularly
called discounted cash flow methods or DCF
methods of project appraisal.
• Once the mathematical framework is understood
than the real challenge is in estimating and providing
the model the right inputs.
• Needless to say as inputs are related to the future,
the numbers are best estimates of the management
based on their past experience and the knowledge
of the industry.
• The managements will therefore test a series of
scenarios by varying the input factors and see the
sensitivity of the key outputs to it.
CB Inputs – Summary

23. • Simple Products Inc. is contemplating a new
investment project, the details of which are given
below.
• Project outlay : $ 200 mn. out of which $120 mn. is
to be spent on fixed assets with rest ($80 mn.) on
gross working capital. The entire investment will
happen at one shot at the beginning of the project.
• Funding : Equity capital = $ 80 mn., Long term debt
i.e. debentures = $ 60 mn. @ 6.5% p.a. Short term
bank borrowings = $ 40 mn. @ 5% p.a. Trade Credit
= $20 mn.
• Project life : 5 years. Salvage value of fixed assets is
estimated at $ 40 mn. Liquidation value of working
capital will be equal to its book value = $80 mn.
CB Inputs – Example 1

24. • Solution
CB Inputs – Example 1
• Gross WC – (ST bank Loan +Trade Credit)
• $80mn. – ($40mn.+$20mn.) = $20mn.
Working
Capital
Margin
• Fixed Assets + Net WC = $120mn. + $20mn.
= $140mn. Another way to look at it is…..
• Equity Capital + LT Loans = $80mn. + $60mn. =
$140 mn.
Long Term
Funds
Invested
• Investment in Fixed Assets + Working Capital
marginInitial Flow

25. • Solution
CB Inputs – Example 1
• Initial Flow + Operating Flow +Terminal Flow
Net Cash
Flow
• Net Salvage Value of FA + Net recovery of WC
margin = $40mn. + $20mn. = $60mn.
Terminal
Cash Flow
• Profit After Tax + Depreciation - for each of the
5 years
Operating
Cash
Flows

26. $ mn. Year
0 1 2 3 4 5
Fixed Assets -120
Working capital margin -20
Revenues 100 100 100 100 100
Exp. (excl. depreciation & Interest) 60 60 60 60 60
Depreciation 12 10 8 6 5
Profit before tax 28 30 32 34 35
Tax 10 11 11 12 12
Profit after tax (PAT) 18 20 21 22 23
Net salvage value of fixed assets 40
Net recovery of work. cap margin 20
Initial flow -140
Operating flow 30 30 29 28 28
Terminal flow 60
Net cash flow -140 30 30 29 28 88
CB Inputs – Example 1
Operating Flow = Profit after tax + Depreciation
(Note that Interest is excluded and after tax
cash flows are considered).
• Solution

27. Year
In $ mn. 0 1 2 3 4 5
Fixed Assets -120
Working capital margin -20
Revenues 100 100 100 100 100
Exp. (excl. depreciation & Interest) 60 60 60 60 60
Depreciation 12 10 8 6 5
Profit before tax 28 30 32 34 35
Tax 10 11 11 12 12
Profit after tax (PAT) 18 20 21 22 23
Net salvage value of fixed assets 40
Net recovery of work. cap margin 20
Initial flow -140
Operating flow 30 30 29 28 28
Terminal flow 60
Net cash flow -140 30 30 29 28 88
Net cash Flow = Initial Flow + Operating Flow +
Terminal Flow
CB Inputs – Example 1
• Solution

28. CB Inputs – Example 1
$ mn. Year
0 1 2 3 4 5
Initial flow -140
Operating flow 30 30 29 28 28
Terminal flow 60
Net cash flow (A) -140 30 30 29 28 88
• Solution – NPV & IRR
PV factor @12% (B) 1.0000 0.8929 0.7972 0.7118 0.6355 0.5674
PV of cash Flows (A)x(B) -140 27 24 21 18 50
NPV (Sum of PV of cash
Flows)
-1
IRR (Use Excel IRR
function)
11.77%
Project will be rejected
as the NPV is
negative/IRR is lower
than the required rate of
return.

29. • Depreciation is charged on both the new and old
plants at 20% as per WDV (written down value)
method.
• The new automated plant is expected to result in an
annual saving of $10mn. in manufacturing costs.
Investment in working capital would remain
unaffected. The tax rate applicable is 35%.
With the above information, work out the incremental post-
tax cash-flows associated with this project. If the minimum
required rate of return is 15% p.a. calculate the NPV. What
is the IRR of the project?
CB Inputs – Example 2

30. CB Inputs – Example 2
$mn. Year
0 1 2 3 4 5
Net investment in plant -40
Savings in manufacturing costs 10 10 10 10 10
Depreciation on old plant (1) 2 2 1 1 1
Depreciation on new plant (2) 10 8 6 5 4
Incremental Depreciation on new
plant (2 minus 1)
8 6 5 4 3
Incremental taxable profit 2 4 5 6 7
Incremental tax 1 1 2 2 2
Incremental profit after tax (PAT) 1 2 3 4 4
Net salvage value of fixed assets 30
• Solution
We need to factor-in the annual savings in
manufacturing cost as an inflow

31. CB Inputs – Example 2
$mn. Year
0 1 2 3 4 5
Net investment in plant -40
Savings in manf. costs (A) 10 10 10 10 10
Depreciation on old plant (1) 2 2 1 1 1
Depreciation on new plant (2) 10 8 6 5 4
Incremental Depreciation on new
plant (2 minus 1) (B)
8 6 5 4 3
Incremental taxable profit (A-B) 2 4 5 6 7
Incremental tax 1 1 2 2 2
Incremental profit after tax (PAT) 1 2 3 4 4
Net salvage value of fixed assets 30
• Solution
Only additional or incremental profit should
be considered.

32. CB Inputs – Example 2
$mn. Year
0 1 2 3 4 5
Net investment in plant -40
Savings in manf. costs (A) 10 10 10 10 10
Depreciation on old plant (1) 2 2 1 1 1
Depreciation on new plant (2) 10 8 6 5 4
Incremental Depreciation on new
plant (2 minus 1) (B)
8 6 5 4 3
Incremental taxable profit (A-B) 2 4 5 6 7
Incremental tax 1 1 2 2 2
Incremental profit after tax (PAT) 1 2 3 4 4
Net salvage value of fixed assets 30
• Solution
This is the salvage value of the new plant
after 5 years. Note that the old plant’s
salvage value is expected to be zero and
hence the new plant salvage value is taken
as it is. If the old plant had an estimated
value greater than zero than this amount
needs to lessened from the new plant’s
salvage value.
Also the net recovery of working capital
margin is also expected to be zero.

33. CB Inputs – Example 2
• Solution – NPV & IRR
$mn. Year
0 1 2 3 4 5
Initial flow (Net investment in
plant)
-40
Operating flow 9 9 8 8 8
(Incremental PAT + Incremental
Depreciation )
Terminal flow 30
(Net incremental salvage value
of fixed assets)
Net cash flow (A) -40 9 9 8 8 38
(Initial flow + operating flow
+ terminal flow)
PV factor @15% (B) 1.0000 0.8696 0.7561 0.6575 0.5718 0.4972
PV of cash Flows (A)x(B) -40 8 7 5 5 19
NPV (Sum of PV of cash Flows) 3
IRR (Use Excel IRR function) 17.74%

34. CB – Risk Analysis
The basics of
the risks
associated with
long term
investments &
how to factor –
in such risks

35. 1. Business Risk – effect of high proportion of
fixed cost - example
Three Key Risks
$ mn. Alpha Inc. Beta Inc.
Normal Recession Normal Recession
Sales 200 120 200 120
Variable
Cost
-100 -60 -160 -96
Fixed Cost -80 -80 -20 -20
Profit/Loss 20 -20 20 4
Change in
Sales (%)
-40 -40
Change in
Profits (%)
-200 -80

36. $ mn. Alpha Inc. Beta Inc.
Normal Recession Normal Recession
Sales 200 120 200 120
Variable
Cost
-100 -60 -160 -96
Fixed Cost -80 -80 -20 -20
Profit/Loss 20 -20 20 4
Change in
Sales (%)
-40 -40
Change in
Profits (%)
-200 -80
1. Business Risk – effect of high proportion of
fixed cost - example
Three Key Risks
Alpha has a higher proportion of fixed
cost while Beta has a lower proportion.

37. $ mn. Alpha Inc. Beta Inc.
Normal Recession Normal Recession
Sales 200 120 200 120
Variable
Cost
-100 -60 -160 -96
Fixed Cost -80 -80 -20 -20
Profit/Loss 20 -20 20 4
Change in
Sales (%)
-40 -40
Change in
Profits (%)
-200 -80
1. Business Risk – effect of high proportion of
fixed cost - example
Three Key Risks
The negative effect of fixed cost is felt when economic
downturns happen. By the same token the high proportion of
fixed has a positive effect when the economy booms.
Alpha is said to have a high operating leverage as compared
to Beta.

38. 2. Financial Risk
v. Thus Financial Leverage =
Long Term Debt/Shareholders funds.
v. A 1:1 ratio indicated that debt and equity capital are
equally employed. A ratio greater than 1 indicates
higher level of debt in relation to equity and vice
versa.
vi. The higher the financial leverage, the greater the
fixed obligations, the greater the risk of non-payment
with changing economic conditions as operating
cash flows get effected.
Three Key Risks

39. 3. Portfolio or Market Risk
i. This arises from the variability of returns to the
shareholders as a result of the business and
financial risk.
ii. This risk to shareholders is called firm specific risk.
iii. Shareholders however can diversify this risk by
holding a well diversified portfolio where the adverse
performance of one investment can be offset by
better performance by others.
iv. In such a situation the variability of return to
shareholders arise due the macro factors – such as
interest rates, exchange rates etc. that make the
markets go up or down
Three Key Risks

40. v. If the economy does well, the firm normally
should do well and hence its projects.
vi. Due to this the stand-alone risk can be
considered to a close proxy for difficult-to-
measure business and market risk.
vii. To assess the stand alone risk of the project the
starting point is to assess the uncertainty
inherent in the projected cash flows.
viii. Thus when a firm projects sales of 50000 units
@ $ 500, the firm knows that the actual figure is
very likely to be different and the figures are just
expected values.
Project Risks

41. • Once we have a measure of the risk this can
then be incorporated in the discount rate.
• The discount rate can be seen to be made up of
two components
• The risk free rate plus
• A risk premium for the risk in the project
• This additional return for the risk taken
increases as the perception of risk increases.
• The higher the expected return or discount
factor the lower the NPV.
Factoring-in the Risks

42. • Any new project requires a lot of administrative and
coordination efforts.
• The human resources management is also an
additional factor given the internal equations/in-
equations and politics that most organizations face.
• To make sure that the project is truly worth over and
above these and such ‘headache’ or ‘intangible’
factors, managements usually set minimum hurdle
rates.
• These rates are decided a matter of policy & arise
from the past experiences, return expectations of
shareholders, overall interest rate environment etc.
Factoring-in the Risks

43. • Firms do not look at capital investment decisions
on a stand alone basis.
• It is considered within the overall business
context, its goals and strategic direction.
• Every investment decision is therefore looked at in
the context of existing investments i.e. a portfolio
approach is taken.
• Thus when proposals for capital investment come
from various parts of a firm, apart from the returns
that the project offers firms also evaluate
• The market attractiveness of the proposal
• The competitive strength of the firm
Strategic Considerations

44. • Firms do not look at capital investment decisions
on a stand alone basis.
• It is considered within the overall business
context, its goals and strategic direction.
• Every investment decision is therefore looked at in
the context of existing investments i.e. a portfolio
approach is taken.
• Thus when proposals for capital investment come
from various parts of a firm and apart from the
returns that the project offers firms also evaluate
• The market attractiveness of the proposal
• The competitive strength of the firm
Strategic Considerations
It is indicated by a firm’s market share and
its growth rate, brand loyalty, profitability,
and technological and other comparative
advantages.

45. Mckinsey-GE Portfolio Matrix
High Medium Low
High
Invest &
Grow
Invest &
Grow
Improve &
Defend
(selective
Investment)
Medium
Invest &
Grow
Improve &
Defend
(selective
Investment)
Harvest or
Divest
Low
Improve &
Defend
(selective
Investment)
Harvest or
Divest
Harvest or
Divest
Business Strength (BS)
MarketAttractiveness(MA)

46. MarketAttractiveness(MA)
Mckinsey-GE Portfolio Matrix
High Medium Low
High
Invest &
Grow
Invest &
Grow
Improve &
Defend
(selective
Investment)
Medium
Invest &
Grow
Improve &
Defend
(selective
Investment)
Harvest or
Divest
Low
Improve &
Defend
(selective
Investment)
Harvest or
Divest
Harvest or
Divest
Business Strength (BS)
Where either MA or BS is
relatively low, get maximum
out of existing business i.e.
try and maintain cash flows by
incurring only replacement
capex, tight control on WC
and other costs.

47. Capital Budgeting – Process
The processes
involved in
long term
investment
decisions & its
implementation

48. • The CB process is broadly on the following lines
• Idea generation – scanning the
market/environment for opportunities or looking at
internal issues/bottlenecks and finding solutions
• Assembling the proposed investments –
• Classification of investments into replacement,
expansion, diversification, new product etc.
• Defining the project clearly i.e. purpose,
rationale, time frame, benefits etc. both in
technical & economic terms. This normally
requires information & data gathering –
internally & externally.
CB – Process Explained

49. • Review alternatives
• Evaluate the consequences of not implementing
the project.
• Based on the above the project may be
accepted/approved or sent for review/additional
details.
• Implementation, monitoring & control
• A map of set of linked activities, timelines for
each, responsibilities & authority for the each
task etc. is set out, communicated and agreed.
• Initiation activities such as raising funds, placing
equipment orders etc. are done as per above.
CB – Process Explained

50. • Time delays, cost escalations, contingencies not
foreseen etc. are critically examined and
required action/measures taken – in adverse
situations even abandoning the project.
• Post implementation audit – done after a year or so
after implementation
• Is the project delivering the intended
objective/benefit?
• Forecast Vs actual cash flows
• Any thing that can be done to bring it to the
intended track if need be?
• Learning for future appraisals &
implementations.
CB – Process Explained

51. Thank You

52. 1
Flevy (www.flevy.com) is the marketplace
for premium documents. These
documents can range from Business
Frameworks to Financial Models to
PowerPoint Templates.
Flevy was founded under the principle that
companies waste a lot of time and money
recreating the same foundational business
documents. Our vision is for Flevy to
become a comprehensive knowledge base
of business documents. All organizations,
from startups to large enterprises, can use
Flevy— whether it's to jumpstart projects, to
find reference or comparison materials, or
just to learn.
Contact Us
Please contact us with any questions you may have
about our company.
• General Inquiries
support@flevy.com
• Media/PR
press@flevy.com
• Billing
billing@flevy.com