a) List the distinctive features of capital investments which make it worthwhile developing and applying a special set of techniques to evaluate them

Capital investments have very distinct features which make it worthwhile developing and applying a special set of techniques to appraise these decisions. These features are:

q     The sums involved are relatively large.  Bad decisions can have very serious long-term consequences.

q     The timescale over which the benefits will be received is relatively long, with greater risks and uncertainty in forecasting future revenues and costs.

q     The nature of a business, its direction and rate of growth is ultimately governed by its overall investment programme.

q     The irreversibility of some projects due to the specialised nature of certain assets for example, some plant and machinery bought with a specific project in mind could have little or no scrap value.

q      In order to complete projects on time and within budget, adequate continuous control information is required.

q     Capital investment is long-term and the recoupment of investment may involve a significant period of time.  This waiting period has a cost because the money tied up could be used elsewhere to generate a return or earn interest. This is an important principle of financial management which recognises that monies receivable in the future, have less value than if they were received immediately. This is because:

§         By waiting for cash, one is foregoing the opportunity to invest and earn interest or a return on the investment.

§         The buying power of €1 received today is greater than €1 received in 12 months time due to inflation.

b) Briefly describe the term 'cost of capital', explaining its significance in relation to appraising capital projects

All investment projects require funding. Generally, funding can be classified into:

q     Equity funding, where investors buy an equity or ownership share in a project. This is done through the issue of shares or by retaining profits in the business.

q     Debt, where the company can borrow or issue its own debentures.

Each source of finance has a cost. The cost of debt is the interest rate that applies to the debt. The costs of equity finance are the dividends and increases in share price expected by shareholders. It is not enough for a business to generate a profit. A business must generate a profit level sufficient to cover the cost of capital. Hence cost of capital becomes the benchmark or minimum required return for a business. Thus a business is only truly profitable when its actual return on assets is greater than its cost of capital. For example a company invests €150,000 in two second-hand limousines. The investment has been financed through a bank loan of nine per cent. In its first year, the cars generate an operating profit of €20,000.  Is this business generating a return greater than the cost of capital.

Ignoring corporation tax, the business achieved an operating profit of €20,000 and hence the return on assets (ROCE) is 13.33 per cent (€20,000 ¸ €150,000). This is greater than the cost of capital of nine per cent and thus the project is truly profitable. Another way to look at this is that the business must make at least €13,500 (€150,000 x 9%) profit to meet the cost of capital.

The business cost of capital is the discount factor to use when discounting future cash flows to present values, as it represents the minimum required return for investors to compensate them for the interest lost, inflation, and risk inherent in any investment. Should a business be financed through a mixture of equity and debt, then a weighted average cost of capital should be calculated and this should be the factor used in discounting future cash flows to present value.