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Capital budgeting: don't take capital expenditure evaluation lightly when acquiring fixed assets, warns Theodore Chen, who recommends the discounted corporate cash flow method.

Making a wrong choice when acquiring capital assets could drain your firm's finances over a long period, since they can't readily be sold off to solve short-term cash flow problems. The capital budgeting process is, therefore, crucial--particularly to SMEs that can't afford to tie up money in under-utilised fixed assets. Yet a big proportion of firms in Hong Kong, where my university is located, don't use any scientific method to inform such decisions.

Capital expenditures usually fall into one or more of the following categories:

* Capacity expansion.

* Equipment replacement.

* Government regulation.

* Cost reduction.

* Efficiency improvement.

* Revenue generation.

Those in the first three categories usually don't call for the application of evaluation methods, while those in the last three do. An example of capacity expansion would be the hiring of extra staff to cope with increased business activity, resulting in the acquisition of office equipment for them. In the case of equipment replacement, no analysis is required if it's a like-for-like substitution. If not, the expenditure could fall within the efficiency improvement category. An example of spending in the government regulation category would include that on legally required safety devices.

Companies generally resort to one of the following four methods of evaluating capital expenditure:

* Payback period. This technique uses cash flows instead of accounting income and aims to determine the time it will take for the investment to be recouped. It considers neither the time value of money nor cash flows after the payback period.

* Accrued accounting rate of return. This method uses accounting income rather than cash flows, but it still ignores the time value of money.

* Internal rate of return (IRR). This determines a rate of return based on trial and error, equating the present value of net cash flows over the life of the project with the initial investment. Say a new piece of plant that cuts operating costs by 101,000 [pounds sterling] at the end of each year for five years incurs maintenance costs of 1,000 [pounds sterling] annually and the initial investment in it is 379,100 [pounds sterling]. Working it out by trial and error, the IRR happens to be ten per cent. Using the present value of the annuity at ten per cent for five years: 3.791 x (101,000-1,000 [pounds sterling])= 379,100 [pounds sterling]. This method is also flawed, as the net cash flow generated from the project each year is reinvested at the internal project rate (ten per cent in this case). This compounding effect can be misleading when the internal rate of return is large and when subsequent investment opportunities are less attractive.

* Net present value (NPV). This removes the flaw from the IRR method by calculating an absolute amount of return. The present value of annual net cash flows minus the initial investment gives the NPV after all outflows have been deducted from inflows on a present value basis. Using the same cost savings as in the IRR example and assuming that the initial outlay is 300,000 [pounds sterling], the NPV is computed as 79,100 [pounds sterling]--ie, (3.791 x 100,000 [pounds sterling])--300,000 [pounds sterling]. This approach is less popular with non-accountants, who prefer to see a percentage return rather than an absolute amount with no base to relate to.

Seeking a better way, the Mead Corporation in the US came up with the discounted corporate cash flow (DCCF) method in the early seventies, whereby all cash inflows were compounded to the end of the project and all cash outflows were discounted back to year zero.

Say a firm buys plant for 1m [pounds sterling] for the purposes of efficiency improvement and the annual savings from using it, less maintenance costs, are 250,000 [pounds sterling] annually for five years. The DCCF works as follows: the projected corporate opportunity rate for each year (different each year) is used to compound the 250,000 [pounds sterling]. For simplicity, assume that the opportunity rate stays at eight per cent a year for the next five years. The annuity of 1 [pounds sterling] in arrears for five years at eight per cent is 5.8666, giving the compounded future value of cash inflows as 250,000 [pounds sterling] x 5.8666 = 1,466,650 [pounds sterling].

Now, 1,466,650 [pounds sterling] /1,000,000 [pounds sterling] = 1.4667 (rounded to four decimal points). The future value factor is 1.4693 at eight per cent for five years, so for this project the DCCF rate is just under eight per cent. This rate is then compared with an internal hurdle rate to determine the acceptability of the project. The method is easy to apply and avoids the flaw of the IRR technique while giving a percentage return for non-accountants.

Regardless of the type of discounted cash flow method you use, you should conduct a project audit six months after its implementation. The recalculated discounted cash flows can be compared with the initial computations and the reasons for the variance used to inform similar projects in the future.

Professor Theodore Chen is head of the department of accounting at Hong Kong Shue Yan College.
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Author:Chen, Theodore
Publication:Financial Management (UK)
Geographic Code:4EUUK
Date:Mar 1, 2006
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