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Understanding Investment

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

Top Management
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
• Selection of Proposals
• Board Review - comments
• Compilation of
Departmental Proposals • Approved Capital Budget
• Compilation of preliminary
Budget • Incorporation in Business Plan
• Departmental

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

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

No No
Irrelevant for Decision Making is futuristic& it varies
with alternative
Case: Choice between the
- Total Cost Approach
Three years together
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
- Relevant Cost Approach

Three years together

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
Computer related cash operating
400,000 100,000
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
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

Training Specialties Technical
Cost Equipment Data
Cost Cost

Supply & Handling
Support Retirement
Cost & Disposal