A Realistic Approach For Capital Expenditures Analysis

Abstract

Abstract This paper briefly reviews the various financial analysis techniques to judge capital expenditure projects. Most of these methods in their basic forms, however, fail to determine the real returns to a company from such capital investments. A procedure is outlined to incorporate the concept of real returns for a realistic appraisal of a capital expenditure project. Introduction The capital expenditures in the petroleum industry are analyzed with the help petroleum industry are analyzed with the help of several techniques, such as discounted cash flow rate of return, net present value, payback and operating rate of return. Among the lesser known and practiced methods are E.A.A. (equivalent annual amount) rate of return and some ratio of present value of profits to present value of investments. Beyond the apparent present value of investments. Beyond the apparent advantages and disadvantages, these methods in their basic forms fail to account for the real loss of returns due to inflation and other factors which may be unique to a company. This paper describes the existing financial analysis techniques and then discusses a method which incorporates the concept of real returns which are also adjusted for the company's historical performance. When combined with some form of computerized simulation techniques, this suggested approach can perform a very effective and useful role in proper selection and ranking of the capital expenditure projects. This may also be able to achieve optimum returns under any given set of assumptions. A comprehensive example shows the various profitability measures and their usefulness and profitability measures and their usefulness and limitations. It is then expanded to show the real rate of return which ought to be the true measure of capital expenditure projects. projects. DISCUSSION OF PROFITABILITY MEASURES The various methods to determine the profitability of a project are summarized profitability of a project are summarized below. DCF RATE OF RETURN The discounted cash flow (DCF) rate of return, also known as internal rate of return, is the discount rate which will make the present value of all cash outflows equal to the present value of all cash inflows.