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Understanding Investment

in
Long Term Assets

- A Practical Approach
Drucker… The guru….

"Until a business returns a profit that is greater


than its cost of capital, it operates at a loss.
Never mind that it pays taxes as if it had a
genuine profit. The enterprise still returns
less to the economy than it devours in
resources…Until then it does not create
wealth; it destroys it."
Some “home truths” about Capex
• Good investment projects do not simply
emerge out of woodwork - they have to be
identified, defined and revised
• Non-quantifiable aspects frequently have a
significant impact on the decision outcome
• Estimates are rarely free from bias
• “The child that cries loudest normally gets
the chocolate”
Factory/Branch Level

Investment Proposals

Divisional Divisional
Level Level

Investment Investment
Proposals Proposals

Capex
Appraisal
Top Management
Level
Filter
Investments Selected
Process of Capex Budgeting

Origination of Capex Proposal • Budget Proposal


• Generation of Proposals
• Finance Review/Financing
• Categorisation of proposals Plan
• Evaluation /Screening • Budget Document for
Approval
• Selection of Proposals
• Board Review - comments
• Compilation of
Departmental Proposals • Approved Capital Budget
Document
• Compilation of preliminary
Budget • Incorporation in Business Plan
• Departmental
Reviews/Feedback

Appraisal of Capex Proposal Approval of Capex Proposal


Classification by Needs
• Cost Reduction
– Modernisation
– Upgradation
– Process Improvements
• Revenue Generation
– Expansion
– Diversification
• Operational Necessity
– Reconstruction
– Replacement
– Risk Reduction
• Statutory/Societal compulsions
Cost numbers for Capex

• Relevant & Irrelevant Costs


• Avoidable & Unavoidable Costs
• Sunk Costs & Opportunity Costs
• Apportioned Costs
• Marginal & Incremental Costs
Relevant Information for Decision
Making

Does it Relevant
Is it Yes Yes
vary with for
Futuristic?
alternative? Decision
Making

No No
Relevant
information
Irrelevant for Decision Making is futuristic& it varies
with alternative
Case: Choice between the
alternatives
- Total Cost Approach
Three years together
Work
Main frame station Difference
Revenue 30,000,000 30,000,000 -
Operating Costs:
Non-computer related operating costs 26,400,000 26,400,000 -
Computer related cash operating costs 1,200,000 300,000 900,000
Mainframe book value
Periodic write-off as depreciation 1,800,000 -
Or Lumpsum write-off - 1,800,000 -
Current disposal value - (950,000) 950,000
Workstations, written off as depr. - 1,350,000 (1,350,000)
Total operating costs 29,400,000 28,900,000
Operating Income 600,000 1,100,000 500,000
Case: Choice between the
alternatives
- Relevant Cost Approach

Three years together


Work
Main frame station Difference
Computer related cash operating costs 1,200,000 300,000 900,000
Current disposal value - (950,000) 950,000
Workstations, written off as depr. - 1,350,000 (1,350,000)
Total Relevant Costs 1,200,000 700,000 500,000
Rajesh Pande’s reluctance…
Keep Main Buy Work
In the first year
frame station
Revenue 10,000,000 10,000,000
Operating Costs:
Non-computer related operating
8,800,000 8,800,000
costs
Computer related cash operating
400,000 100,000
costs
Depreciation 600,000 450,000
Loss on sale of Main-frame - 850,000
Total operating costs 9,800,000 10,200,000
Operating Income 200,000 (200,000)
People behave in the
way their
performance is
measured
Financial Evaluation - Basics

• Cost numbers for Capex


• Cash flows
• Time Value of Money
• Cost of Capital
• Appraisal Criteria
• Risk
Cash Flows

• Initial investment
– Cost of capital assets
– Installation costs
– Working Capital Margin
– Other startup expenses
Cash Flows

• Operating Cash Flows


– Profit after Tax + Depreciation + Other non-cash
charges + Interest on long term debt(1-tax rate)
• Terminal Cash flows
– Post-Tax proceeds from the sale of capital assets
+ Net recovery of Working capital margin
Biases in Cash Flow Estimates

• Overstatement of Profitability
– Intentional Overstatement
– Lack of Experience
– Myopic Euphoria
– Capital Rationing
– Splitting the Proposal

• Understatement of Profitability
– Salvage values are under-estimated
– Intangible benefits are ignored
Total Cost Visibility
- The Iceberg Effect

Acquisition Poor
Cost Management

Repair
Cost
Training Specialties Technical
Cost Equipment Data
Cost Cost

Transportation
Supply & Handling
Support Retirement
Cost
Cost & Disposal
Cost
Facilities
Cost