The Relevant Cash Flows

Before we proceed to examining the methods of selecting investment projects, let us briefly define the meaning of the terms which we shall be employing.

(a) Net investment outlays

These consist of initial investment outlays required to establish the project, and the subsequent investment outlays which are envisaged at the outset, and are distinguishable from operating cash outlays. Thus, initial investment outlays may comprise expenditure on equipment, installation costs, manpower training, working capital etc. Subsequent investment outlays may include 'second stage' developments, plant extensions etc. The analysis of a capital project is in terms of net cash costs to the firm, so that where tax credits are allowable, these credits must be deducted from the total cash costs to obtain the relevant cash outlay.

(b) Net cash inflows

These are the operating cash flows associated with the investment over the period of its useful life. They are calculated after deducting operating cash expenditure and taxation. Since there may be year-to-year variation in the profile of these net cash flows, and since their periodic pattern is largely guesswork, they are the most difficult cash flows to quantify.

All cash-flow calculations are made on the basis of the estimated useful life of the investment, which is defined as the time interval that is expected to elapse between the time of acquisition or commencement and the time at which the combined forces of obsolescence and deterioration will justify the retirement of the asset or project. The useful life of the investment may be shortened by market changes which will diminish its earnings.

Methods of appraising capital investments

The more commonly used methods of evaluating capital investment proposals are:

(a) the pay-back period;

(b) the accounting rate of return;

(c) the discounted cash flow techniques, of which there are two main forms:

(i) the net present value method (NPV)

(ii) the internal rate of return (IRR).

Planning Capital Expenditure 453

The pay-back period

This method attempts to forecast how long it will take for the expected net cash inflows to pay back the net investment outlays. The pay-back period is calculated as follows:

Net investment outlays

Pay-back period (years) =

Average net cash inflows

The pay-back method has the advantage of simplicity. By advocating the selection of projects by reference only to the speed with which investment outlays are recovered, it recommends the acceptance of only the safest projects. It is a method which emphasizes liquidity rather than profitability, and its limitations may be stated to be:

(a) It lays stress on the pay-back period rather than the useful life of the investment, and ignores the cash flows beyond the pay-back period. Hence, it focuses on breakeven rather than on profitability.

(b) It ignores the time profile of the net cash inflows, and any time pattern in the net investment outlays. Any salvage value would also be ignored. This method, therefore, treats all cash flows through time as having the same value, so that in the example given, the value of £200,000 invested now is equated with £200,000 of net cash inflows over 34 years.

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Read on: Types of Capital Investment Decisions

A capital investment may be defined as an investment which yields returns during several future time periods, and may be contrasted with other types of investments which yield all their return in the current time period. Capital investment decisions may concern the following:

(a) the acquisition or replacement of long-lived assets, such as buildings and plant;

(b) the investment of funds into another firm from which revenues will flow;

(c) a special project which will affect the firm's future earning capacity, such as a research project or an advertising campaign;Types of Capital Investment Decisions