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Capital Expenditure is that expenditure which involves a current outlay of funds in expectation of a stream of benefits extending far into future.
Capital Expenditure therefore includes Additions, Disposition, Modification and replacement of fixed Assets. Capital Investment decision pertain to fixed/ long term assets which are in operation and yield a return over a period of time, usually exceeding one year.
Capital Investment appraisal decision is employed to evaluate Capital Expenditure. These benefits may be either in the form of increased revenues or reduced costs.
Since the benefits from investments are received in some future period and future being Uncertain, therefore an element of Risk is involved.
Capital Investment process includes the process of generating, evaluating, selecting and following up on capital expenditure alternatives. The firm may be confronted with the decision of the Accept- Reject decision. If the project is accepted, the firm would invest in it, if the proposal is rejected, the firm does not invest in it. In general, all those proposals which yield a rate of return, greater than a certain required rate of return or cost of capital, are accepted and the rest are rejected.
The Methods of appraisal Capital Expenditure proposal used are:
1) Average rate of return
2) Payback period method
3) Net present value method
4) Internal rate of return
ARR also known as the Accounting rate of return method is based on accounting information rather than the cash flows. It is calculated in percentage. A project would qualify to be accepted if the actual ARR is higher than the minimum desired ARR; otherwise, it is liable to be rejected.
Besides being easy to calculate, it is easy to understand also.
However this method of evaluating investment proposal suffers from the serious deficiency is that it does not take into account the time value of money. The benefits in the earlier years and later years cannot be valued at par.
Payback period measures the number of years required for the cash inflows to pay back the original outlay required in an investment proposal. If the actual payback period is less than the predetermined payback, the project would be accepted, if not it would be rejected.
The payback period method is an improvement over the ARR approach as it is based on cash flows while ARR takes into consideration the accounting profits.
However payback method completely ignores all cash flows after payback period, this can be very misleading in Capital Investment appraisal. Besides above, it does not take into consideration the entire life of the project during which cash flows are generated. As a result projects with large cash inflows in the latter part of their lives may be rejected in favor of less profitable projects which happen to generate a large proportion of their cash inflows in the earlier part of their lives.
Net Present Value may be described as the summation of the present value of cash proceeds in each year minus the summation of present values of the cash outflow in each year.
The decision rule for a project under NPV is to accept the project if the NPV is positive and reject if it is negative. Zero NPV implies that the firm is indifferent to accepting or rejecting the project. The most significant advantage is that it recognizes the time value of money. Moreover, it considers the total benefits arising over its life time. This method is also instrumental in achieving the objective of maximization of shareholder’s wealth by maximizing the market value of shares. However it is difficult to calculate and understand in comparison to Payback method.
The second problem associated with this is that it requires calculation of required rate of return to discount the cash inflows because different discount rate will give different present values. The relative desirability of a proposal will change with a change in the discount rate.
Internal rate of return – also known as yield on investment, is defined as the discount rate which equates the aggregate present value of the net cash inflows with the aggregate present value of cash outflows of a project. Or in other words, it’s that rate of discount which gives the project NPV of zero.
The use of the IRR, as a criterion to accept involves a comparison of the actual IRR with the required rate of return. The project would be accepted if the IRR exceeds the cut off rate. If the IRR and the required rate of return are equal, the firm is indifferent as to whether to accept or reject the proposal.
CELTIC TIGER:
This word has been taken from the name of a show by Michael Flatley.
“Celtic tiger portrays the oppression of people and tiger symbolizes the awakening of their spirit and their struggle for freedom. Celtic tiger is my finest work to date. “-Michael Flatley. Celtic tiger is a term used to describe the economy of Ireland which undergone a rapid economic growth during 1995 to 2007 which by 2008 underwent a dramatic reversal with a downfall. During 1990 to 2007, economic growth of Ireland grew by an average of 6.5%per year. Besides this there was a huge rise in disposal income and a sharp fall in unemployment. The reason for the above was low corporate taxation rate which being in between 10% to 12.5% through out the late 1990s. At the same time, in 1990s the Irish State organization brought the provision of subsidies and investment capital such as industrial development authority (IDA) Ireland.
Besides above, the wage rate was comparatively less in comparison to prevailing wage.
All the above led to reduction in the cost of capital of the firms. This reduction in cost of capital attracted. High profile companies like Dell , Intel , and Microsoft to locate in Ireland, a state agency, provides the financial, technical and social support to start up businesses. Because of reduction in cost of capital, the different techniques of capital investment went into the favour of establishing companies in Ireland. Cost of capital same as discount rate, being low, results in high present value of cash inflows. It also results in high NPV. Also the actual IRR is greater than the desired IRR. As a result high profile companies decided to make Ireland their next destination office.
But the Economic Crisis which had hit Europe , and other countries washing away jobs, homes, pensions, banks and financial institutions, it has killed off the Celtic Tiger and made life of the workers unsecured.
But the above does not mean that the Capital Investment Appraisal techniques such as NPV,IRR and ARR have become irrelevant post Celtic Tiger. The reason for the downfall of the Ireland were rise in wages in comparison to labour in Eastern Europe which had become comparatively cheaper. Irish Banks like their counterparts in other countries got involved in Housing Bubble during Global crisis. This led to drying up of Foreign Investment in Ireland.
The end result was Deficit Budget.
Due to the depth of the recession, of course companies do not have budgets to Invest. But it does not lead to the conclusion that NPV, IRR and other techniques have become irrelevant. Recession is not a long term phenomenon. More over NPL and IRR and other techniques are related with the Investment of funds. So whenever the companies have funds they will have to make plans for the investments. NPV, IRR and ARR are related with the planning of long term investment. Without proper planning of investment in the long term the company cannot run properly.
So NPV, IRR PAYBACK PERIOD AND ARR will never become Irrelevant.