CAPITAL EXPENDITURE ANALYSIS IN AN ISLAMIC FRAMEWORK

CAPITAL EXPENDITURE ANALYSIS IN AN ISLAMIC FRAMEWORK

1.    

  Introduction

Outlays on fixed assets with expected return spreading over a number of years are commonly termed as “capital expenditure”. Decisions for such outlays are made by business organization on the basis of whatever information can be obtained about a certain proposal for investment. But as heavy amounts of capital are involved and the returns are to be realized in an uncertain future, the stakes are weighed quite carefully before a certain proposal is accepted for implementation. Examples for such decisions are quite common in large organizations. For example, whether a certain machine should be bought or an older one be repaired. Whether a building to be taken on lease or a new one be constructed. Whether a new product to be developed or the old line be reduced to specialize in a view products, etc.

In advanced countries, business organizations have developed sophisticated techniques to evaluate investment proposals before they are carried out. The executives of large organizations are equipped with instruments which provide quick and, to a large degree, accurate information to make everyday decisions on capital expenditure. This has now become all the more compelling because survival in a competitive economy requires efficiency in production and reduction in costs. The capital expenditure techniques provide a cost-conscious vision to the decision-maker which, in turn, ensures survival in the market. In underdeveloped countries, where sellers’ market prevails due to economic and non-economic rigidities, such a careful and refined analysis about an investment proposal is hardly resorted to. Instead, the business elite follow certain hunches or rules of thumb for making investment decisions. Obviously, for the modern techniques of capital expenditure analysis are of little interest. But it is the fact that these techniques lend vision to the decision-maker to see through the fog of uncertain future and help arrive at rational decisions.

The idea of discussing capital expenditure analysis in a Riba-free framework owes it significance to modern techniques which are deeply embedded in some sort of discount rate which is, of course, interest rate. Although there are techniques as payback method and accountants rate of return, as we shall see later, which are free from interest calculations, valid objections have been raised against the limited utility of those techniques. This gives rise to an obvious question for a Muslim thinker: what can be a possible method of evaluating investment proposal while taking all those factors into consideration in which an interest-oriented analysis is imbedded and also remaining outside the orbit of the operation on interest in the economy? In fact the question is so obvious that it was raised by a Turkish economist who, while ad vocating the prohibition of interest in the entire economy, conceded that in the absence of any other proposal, modern techniques of investment analysis will have to be accepted. Prof sabri f. ulgener wrote.

“over and above its simplest aspect as a premium paid to the lender, it server as the most dependable discount factor in evaluating and comparing different investments and plays in this capacity a major role in determining the overall structures of investment on production.”

“The crux of the problem for underdeveloped countries is to differentiate between interest as a surplus and interest as factor in computing the overall efficiency of their economies.”

This chapter is an attempt to find out and suggest a proposal to evaluate capital expenditure in a riba-free framework. The writer makes no claims about the originality or uniqueness of the proposal but he has tried to meet all requirements of an efficient tool of Investment analysis in a riba-free framework. The scheme of the chapter is as follows:

A brief survey of modern techniques of capital expenditure analysis is presented to put the reader in the right perspective. It is followed by the proposal and its illustrations made by the present writer. Before we proceed to the body of the chapter, certain assumptions must be made here.

First, the present chapter deals with investment decisions in the private sector, where each project has definite steams of costs and benefits. It does not discuss public sector investment where social or political rather than economic considerations are dominant in making investment decisions. However, the present analysis may be applied, with suitable modifications. To such public sector enterprises which are commercial in nature.

Second, for most of the time we shall be assuming that the investments under consideration are of a conventional nature i.e. periods of investments are followed by periods of returns.

Third, the costs and benefits are definable in each period of time, so that cash flows are not continuous but take place at certain points of time.

Fourth, a period of time may be of any length, say a year, a month, a week or a day.

Fifth, the economy in which the above analysis is being conceived is riba-free. We shall not discuss the rationale of the prohibition of riba in this chapter.

A.    Brief survey of prevalent practices

Organizations differ in their criteria for investment and so do the methods adopted for analyzing a capital expenditure proposal. Quite often method is supplemented by two or more techniques to ensure the soundness of a decision. Similarly, local requirements of an organization, sometimes, suggest modifications to the commonly used methods and the range of such modifications is quite wide. The present chapter will give a brief survey of the most popular methods. The description is intended neither to be exhaustive nor analytical but only to serve as a background for subsequent discussion.

The most commonly used methods are:

1.      Payback method

2.      Accountants rate of return (ARR)

3.      Discounted cash flow rate of return (DCFR)

4.      Net present value method (NPV)

5.      Machinery and allied product institute method (MAPI)

1.      PAYBACK METHOD

It means within how much time the investment will pay back its cost. The answer is usually in years, though shorter periods are also taken as a measure. The investment which can payback its initial costs earlier is considered better.

But this method is often criticized for two reasons:

a.       It does not take into account the money value of time. Two proposals, A and B with equal initial costs are ranked equally profitable if they pay back their costs in equal number of years; although ‘A’ may pay back 90% of its costs in the first year and ‘B’ may take 3 year to pay back the same proportion of its cost. This obviously is not rational. Proposal A, which pays back a larger proportion is cost earlier should be considered better but the pay back method does not tell this.

b.      Secondly, it does not take into consideration the proceeds after the initial cost is recovered nor does it give due weight to any dismantlement costs. For example, A and B with equal initial costs and the same payback period are considered equally useful although ‘B’ may cease to give any return after one year of payback and ‘A’ may continue to yield a return over the next 5 years. Similarly dismantlement costs and scarp values after the payback period are ignored.

Because of these defect, this method is often criticized. But it is interesting to note that it is still the most popular method used by the business organizations in the U.S.A.

2.      ACCOUNTANTS RATE OR RETURN (ARR)

This is a simple measure of the profitability of an investment. It means the rate of return on capital. For example, if the return on capital is 6%, the ARR will be 6% and it can be ranked against other proposals to decide the profitability of a project. There is a wide range of methods to compute the ARR. The variations in computation are due to different definitions adopted for costs and benefits by different organizations. Problems such as depreciation, income tax, deferred payments, annual dividends, reserves and total costs and benefits etc. lend room for discretion to the management. Irrespective of the fact that assumptions are made, it is essentially a measure of rate of return on an investment.

This method is often criticized for not taking into consideration the money value of time. It ignores which benefit is derived earlier and which has been delayed for a number of periods. Despite the criticism, after payback method, it is one of the most commonly the techniques by business organizations.  

3.      Discounted cash flow rate of return (DCFR)

Both the above methods are often criticized for ignoring the value of time. The discounted cash flow method has been devised to give due weight to the time of outlays and proceeds.

There are three valid reasons for doing so. Firstly, a rupee today is worth more than e rupee a year after, due to inflation which reduces the purchasing power of money over time. Secondly, the nearer a date of return on an investment is, the less uncertain is its realization, because distance in time often entails uncertainty. Thirdly, funds generated by project at an earlier date become available for reinvestment. Because of these reasons it was considered necessary to give due weigh to the timing of outlays and proceeds. Thos weight is provided by discounting the expected returns on capital at a certain rate of interest over the life of the project. What is discounting? It is simply reserve of compounding. If we compound 100 rupees at 6% rate of interest for one year it will be Rs. 100 (1+0.06)¹ = 106. The same amount invested for 2 years at 6% would be 100 …….. This process is compounding and the opposite of it is known as discounting. In discounting we ask how much should be invested today to get Rs….. compound interest after 1,2,4, etc. years. The formula is the reverse for compounding : i.e

…….

It means to get Rs.100 after one year at 6% rate of interest, a sum of Rs.94.3 may be invested today. Similarly we should invest Rs. 89/ - today to get Rs. 100/ - after two years at 6 % rate of interest.

In the DCFR, the essential question is: what should the rate of interest be that will equalize proceeds from investment to its capital outlays? For example, if a project costs Rs. 12.000/ - today and it is estimated that over 5 years it will generate cash worth Rs. 16.000/ - what should the rate of interest be with which Rs. 16.000/ - be discounted to give an answer equal to Rs. 12.000/ -? This is found by trial and error. The proceeds of each year are discounted at probable rate and a total is arrived with the capital outlays. If the capital outlays exceed the cash proceeds, the rate of discount is lowered and fresh calculations are made. Similarly, if the discounted value of the cash proceeds is larger than the cash outlays, the discount rate is increased. In the process of trial and error a rate of discount is found which renders the expected proceeds equal to the cash outlays. The rate thus arrive guides management about the profitability of a project. Usually the market rate of interest at which funds are available for investment is also considered before deciding on an investment proposal.

For facility of computation tables of discounted value have been devised.

The method is unsuitable for two reasons. Firstly, time consuming computations are involved and business executives avoid such exercises. Secondly, it has been conceived in an economy where capital entails a fixed cost i.e., rate of interest. Without entering into the discussions of rationale of the prohibition of interest in a Muslim economy, it is admitted that the method is not acceptable from the Islamic point of view. In fact, one reason the present chapter is being attempted is to find an alternative for evaluating investment proposal which takes money value of time into consideration while remaining within a riba-free framework.

4.      New Present Value Method (NPV)

A sister approach for evaluating investment proposals is NPV. The question to be answered is: what shall the net present value of investment over the life of the project be? The net present value is found out by discounting the cash outlays and cash proceeds at a given rate of interest over the life of the project. The difference of the present value (discounted value) of the cash outlays and cash outlays and cash proceeds is known as net present value.

Projects are ranked according to NPV to decide the desirability or otherwise of a proposal.

In this method the rate of discount is that which is acceptable to the management.

There is a slight difference between the DCFR and NPV and both are accepted as the most suitable tools for capital budgeting. But NPV is also not acceptable to us for reasons stated under DCFR.

5.      Machinery and Allied Product Institute Method (MAPI)

Originated by George Terborgh at the machine and allied products institute, U.S.A., in 1949, the method is used for evaluating minor capital project and to big outlays. Often questions like a machine now or a year later or a product now or six months hence etc. are posed to the management. This method with the help of detailed calculations and charts devised for specific purposes divides average benefits by average investment and finds out a rate known as MAPIR. It is the measure of profitability of a certain proposal.

Due to involved calculations and its being of recent origin this method is not very popular and its practice is limited to a few organizations even in the U.S.A. moreover, the MAPI also does not take into consideration the money value of time.

2.      INVESTMENT EVALUATION OF RIBA-FREE FRAMEWORK

The proposal in the succeeding paragraphs is essentially an alternative for the DCFR and NPV. The rest of the methods may be used in the Islamic as well as in other economic framework. While the basic idea that time has value and due consideration should be given to the timing of cash flows is sound and acceptable, the capital expenditure analysis techniques have utilized the concept of fixed cost of capital which is un-Islamic. Thus a necessity arose to think of an alternative formula which, besides having the characteristics of simplicity and rationality also incorporates the money value of time.

The proposal method may be termed as “investible surplus method” or ISM. The essential question is how much investible surplus will a project generate during its life time? The answer is found by calculating the number of years for which in investable surplus (after recovering the initial cost of the project) remains with the organization multiplied by the quantum of such a surplus. For example, a project with a 5-year life costing Rs.2,000/ - recovers its cost in 2 years and thereafter it generates Rs.2,000/ - for each of the next 3 year. The investible surplus with the organization shall be (2000*2) + (2000*1) + (2000*0) = 6000, assuming the surplus was generated at the end of the 3^rd, 4^th and 5^th years and remained available for 2, 1, and 0 year.

Different investment proposals may be ranked in comparison with each other in respect of the investible surplus they generate.

Algebraically, the calculations may be made by using the following formulae:

……..

….

Similarly, cost of the project can be compared with the investible surplus to calculate investible surplus rate as follows:

……..

Formulae, 1 and 2 above can be utilized only when the cash flows are discreet and are considered to take place at the beginning of a period.

3.       PATTERN OF CASH FLOW

Computations with the help of 1 and 2 above will be illustrated in the following paragraphs. But before this is done a word is necessary on the patterns of investment and their cash flows. The actual cash flows of on organization can be numerous and no exhaustive list can be prepared. However, typical patterns have been sketched on the following diagrams:

……………

The horizontal axis measure time, while the vertical axis measures the investible surplus by substracting costs from benefits. In figure 8.1 the cash flow is a simple one, where initial costs are followed by a series of cash proceeds with a zero scrap value of the project and no intermediate maintenance and replacement costs.

In figure 8.2 initial costs are followed by periodic returns and replacement costs with zero scrap value.

In figure 8.3 initial investments is followed by a series of cash proceeds with a dismantlement cost at the end of the period.

Various combinations and permutations of these patterns can be visualized but these basic patterns have been selected for illustrative purposes only.

Before an investments decisions is made, the patterns of cash flows are visualized in detail and further analysis depends on the accuracy or otherwise of these patterns.

Now we shall illustrate the application of the above formula. The illustrations will follow the patterns of cash flow discussed above.

…..

…..

…..

ADVANTAGE OF ISM OVER THE OTHER METHODS

1.      Over payback method does not measure profitability of a project, while the ISM does so.

a.       The payback method does not measure profitability of a project, while the ISM does so.

b.      The payback has a bias against longer-lived investments, but the ISM does not have any such bias.

c.       The payback does not consider the cash flows after the cost has been recovered while the ISM takes into account all the cash flows over the life of the project.

d.      The payback ignores the money value of time while the ISM gives due weight to the timing of outlays and proceeds.

2.      Over ARR

The ARR does not consider the money value of time. The ISM takes care of this aspect also.

3.      Over DCFR and NPV

a.       But the methods have been conceived in a capitalistic framework where riba is used for discounting the cash flows. The ISM, mostly relevant in a riba-free framework, ignores the rate of interest as a central idea.

b.      Moreover, the ISM is simple to understand and apply as compared to both of these methods.

4.      Over MAPI

MAPI is difficult to use and does not take into account the money value of time. The ISM is simple to use and gives to due weight to timing of cash flows also.

Concluding remarks

The investible surplus method has been proposed with all humality to be tried and modified by business organizations operating in riba-free framework. It is neither the “best” nor the “only” method to evaluate an investment proposal. Its success, like that of other methods, lies with the prudence and care with which a management uses it. The largest area of fallibility is the forecasting of cash proceeds. The management must be objective and clear about factors which have been taken into consideration while mapping the cash flows. It is always advisable that ISM is supplemented with such other techniques as sensitivity analysis, project evaluation and review technique (PERT), critical path method (CPM) etc.

A word of caution at the and. The ISM takes into account only the time period for which investible surplus remained available. It, however, ignores the possibilities, opportunities and expected return (losses etc.) from these funds. In actual practice these questions are of paramount importance and will not be ignored before making a final decision.