CAPITAL

INVESTMENT
DECISION
 Capital Investment Decision
Capital investment decisions involve the judgments made by a management team in regard to how funds will
be spent to procure capital assets. Capital investment decision is also known as CAPITAL BUDGETING

There are a number of factors that management must consider when making capital investment decisions,
such as:

 How well an investment fits into the long-term strategy of the business.
 Whether a projected increase in sales for which capacity is being increased will actually occur.
 Whether a projected increase in fixed assets will increase the breakeven point of the business, requiring
the firm to generate more sales before it can earn a profit.
 Whether the investment will improve the capacity of the firm’s bottleneck operation, thereby increasing
the throughput of the organization.
 Whether the cash flows from the investment will generate a positive return on investment.
 Whether an investment to replace an asset can be deferred by enhancing the maintenance of the existing
asset.
 Whether the investment is required by regulatory requirements, irrespective of the return on investment.
 Whether the firm has sufficient funding available to pay for the assets that it wishes to acquire.
 Decision-making Criteria in Capital Budgeting
How do we decide if a capital investment project should be accepted or rejected?

■ The Ideal Evaluation Method should:

a) include all cash flows that occur during the life of the
project,
b) consider the time value of money,
c) incorporate the required rate of return on the project.

Techniques used in Capital Investment Decisions:

1. Payback Period:
2. Net Present Value
3. Profitability Index
4. Internal Rate of Return
 PAYBACK
• Payback is the number of years required to recover the original cash outlay invested in a project.

• If the project generates constant annual cash inflows, the payback period can be computed
by dividing cash outlay by the annual cash inflow. That is:

PAYBACK= Initial Investment

Annual Cash Inflow

Example
• Assume that a project requires an outlay of 500,000 and yields annual cash
inflow of 150,000 for 7 years.

The payback period for the project is: 3.33 years

(500 150 150 150 150 150 150 150

0 1 2 3 4 5 6 7

Payback period = 3.33 years.

 PAYBACK
• Unequal cash flows –
 In case of unequal cash inflows, the payback period can be found out by adding up
the cash inflows until the total is equal to the initial cash outlay.
Example
• Suppose that a project requires a cash outlay of 20,000, and generates cash inflows of
8,000; 7,000; 4,000; and 3,000 during the next 4 years. What is the project’s payback?

3 years + 12 × (1,000/3,000) months

3 years + 4 months

Acceptance Rule

• The project would be accepted if its payback period is less than the maximum or
standard payback period set by management.
• As a ranking method, it gives highest ranking to the project, which has the shortest
payback period and lowest ranking to the project with highest payback period.
 (500 150 150 150 150 150 ( 300) 0

0 1 2 3 4 5 6 7

 This project is clearly unprofitable, but we would accept it based on a 4-year

payback criterion
 Net Present Value Method

Net Present Value (NPV) is defined as the present value of the future net cash flowsfrom
an investment project. NPV is one of the main ways to evaluate an investment. The net present
value method is one of the most used techniques; therefore, it is a common term in the mind of
any experienced business person.
Net Present Value Method Explanation

Net present value can be explained quite simply, though the process of applying NPV may be considerably more
difficult. Net present value analysis eliminates the time element in comparing alternative investments. Furthermore,
the NPV method usually provides better decisions than other methods when making capital investments.
Consequently, it is the more popular evaluation method of capital budgeting projects.
When choosing between competing investments using the net present value calculation you should select the one
with the highest present value.
If:
NPV > 0, accept the investment.
NPV < 0, reject the investment.
NPV = 0, the investment is marginal
Net Present Value Formula
The Net Present Value Formula for a single investment is: NPV = PV less I
Where:
PV = Present Value
I = Investment
NPV = Net Present Value
Example 1 – Equal cash inflow:
The management of Fine Electronics Company is considering to purchase an equipment
to be attached with the main manufacturing machine. The equipment will cost $6,000
and will increase annual cash inflow by $2,200. The useful life of the equipment is 6 years.
After 6 years it will have no salvage value. The management wants a 20% return on all
investments.
Required:

1. Compute net present value (NPV) of this investment project.

2. Should the equipment be purchased according to NPV analysis?
(1) Computation of net present value:

(2) : Purchase decision:

Yes, the equipment should be purchased because the net present value is positive
($1,317). Having a positive net present value means the project promises a rate of
return that is higher than the minimum rate of return required by management (20% in
the above example).
Example 2 – Unequal cash inflow:

PV Formula Components
Here’s what each symbol means:
•Ct = net cash inflow for the period
•CO = initial investment
•r = discount rate
•t = number of periods
For example, imagine a project that costs 1,000 and will provide 3 cash flows of 500, 300, and 800 over
the next three years. Assume that there is no salvage value at the end of the project and the required
rate of return is 8%. The NPV of the project is calculated as follows:

NPV= 500/(1+8%)¹+300/(1+8%)²+800/(1+8%)³-1,000
NPV= 355.23

(2) Purchase decision:)

Accept the the purchase of equipment.
 PROFITABILITY INDEX

• Profitability index is the ratio of the present value of cash inflows, at the required rate of return, to the initial
cash outflow of the investment.
• The formula for calculating benefit-cost ratio or profitability index is as follows:

Value maximization: It is consistent with the shareholder value maximization principle. A project with PI
greater than one will have positive NPV and if accepted, it will increase shareholders’ wealth.
 INTERNAL RATE OF RETURN (IRR)
The internal rate of return (IRR) is a metric used in capital budgeting to estimate the profitability of potential
investments. The internal rate of return is a discount rate that makes the net present value (NPV) of all cash
flows from a particular project equal to zero. IRR calculations rely on the same formula as NPV does.
 Inventory Management

Inventory management is the

process of ensuring that a company
always has the products it needs on
hand and that it keeps costs as low
as possible.

Inventories are company assets that are

intended for use in the production of
goods or services made for sale, are
currently in the production process, or
are finished products held for sale in the
ordinary course of business. Inventory
also includes goods or services that are
on consignment(subject to return by a
retailer) or in transit.
 Objectives of Inventory Management
• To maintain a large size of inventories of raw material and work-in-
process for efficient and smooth production and of finished goods for
uninterrupted sales operations.
• To maintain a minimum investment in inventories to maximize
profitability.
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Inventory management is a key component of cost of goods sold and thus

is a key driver of profit, total assets, and tax liability. Many financial ratios, such as
inventory turnover, incorporate inventory values to measure certain aspects of the
health of a business. For these reasons, and because changes in Commodity and
other materials prices affect the value of a company’s inventory, inventory
management is important.
COSTS OF HOLDING INVENTORIES
Ordering costs:
Ordering costs are those costs that are associated with the
acquisition of raw materials. In other words The costs that are
spend from placing an order to raw materials to the receipt of
raw materials.
Inventory carrying costs:
Inventory carrying costs are those costs, which are
associated in carrying or maintaining inventory.
 Inventory Models
Two questions:
How Much to order?
When to order ?

1. ABC inventory classification method

2. The economic order quantity (EOQ) mode.
3. Just-in-time management .
1. ABC inventory classification method
Classifying inventory according to some measure of importance and allocating control
efforts accordingly.
A - very important
B - mod. important
C - least important

2. The economic order quantity (EOQ) mode.

is the order quantity that minimizes total holding and ordering costs for the year. Even if all the
assumptions don’t hold exactly, the EOQ gives us a good indication of whether or not current
order quantities are reasonable.

Assumptions of EOQ Model

Only one product is involved

Annual demand requirements known
Demand is even throughout the year
Lead time does not vary Each order is received in a single delivery
Inventory Level = 0 when new order just arrived
There are no quantity discounts
ORDER POINT PROBLEM:
After determination of EOQ, then at what level should the order be placed? If the inventory level is too high , it will be unnecessary
blocks the capital, and if the level is too low, it will disturb the production by frequent stock out and also involves high ordering cost.
Hence, an efficient management of inventory needs to maintain optimum inventory level, where there is no stock out and the costs are
minimum. The different stock levels are
Minimum level
Minimum stock is that level that must be maintained always, production will be disturbed, if it is less than minimum level. While
determination of minimum stock level, lead time , consumption rate , the material nature must be considered
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Minimum stock level = Reorder level-[ Normal usage × Average delivery time]

Reordering level
Reorder level is that level of inventory at in weeks , which an order should be placed for replenishing the current stock of
inventory. Generally, the reorder level lies between minimum stock level and maximum stock level.
Re-order point = Lead time (in days) × Average Daily usage
Average Stock level
Average Stock Level = Minimum level + [Reorder Quantity ÷ 2
Danger Stock level
Danger Level is that level of materials beyond which materials should not fall in any situation. When it falls in danger level it will
disturb production. Hence, the firm should not allow the stock level to go danger level, if at all falls in that level then immediately
stock should be arranged even if it costly.
Danger Level = Average Usage × Minimum Deliver Time ( for Emergency purchase)
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Example:
You’re a buyer for SaveMart. SaveMart needs 1000
coffee makers per year. The cost of each coffee
maker is 78. Ordering cost is 100 per order. Carrying
cost is 40% of per unit cost. Lead time is 5 days.
SaveMart is open 365 days/yr. What is the optimal
order quantity & ROP? ROP = Lead time (in days) × Average Daily usage
Average Daily Usage = 1,000/365 l Daily demand
EOQ=√ 2( 1,000)(100)/78(40%)
= 2.74
= 80 coffeemaker
ROP= 5 X 2.74
= 13.7
3. Just-in-time management

Also known as the Toyota Production System, JIT is a common inventory management technique and type of
lean methodology designed to increase efficiency, cut costs and decrease waste by receiving goods only as
they are needed. JIT was originally formed in Japan as a response to the country’s limited natural resources,
leaving little room for wastage.
Today, Just in Time systems are used by many businesses, and it has influenced related lean inventory
management techniques like IBM’s Continuous Flow Manufacturing (CFM). The rise of drop shipping has made
JIT inventory management more appealing for retailers, as it allows them to sell a product before buying it, then
purchase the item from a third party and have it shipped directly to the customer.

Advantages:
Lower inventory holding costs
Improved cash flow –
Less dead stock

Disdvantages:
Problems with order fulfillment
Little room for error
Price shocks