Capital Budgeting. Capital Expenditures Refer to substantial outlay of funds the purpose of which is to lower costs and increase net income for several.

Capital Budgeting

Capital Expenditures• Refer to substantial outlay of funds the

purpose of which is to lower costs and increase net income for several years in the future. It includes expenditures that tie up capital inflexibility for long periods. It covers not only outlays for fixed assets but also expenditures for major research on new products and methods and for advertising that has cumulative effects

Classes of Capital Expenditures• Replacement investments• Expansion investments• Product line or new market investments• Investments in safety and/or environmental

projects• Strategic investments• Other investments

Capital Budgeting• Planning and control of capital expenditures• Provides a systematic evaluation of the firm’s

alternatives• The process in which a business determines whether

projects such as building a new plant or investing in a long-term venture are worth pursuing. Oftentimes, a prospective project's lifetime cash inflows and outflows are assessed in order to determine whether the returns generated meet a sufficient target benchmark. (investopedia)

Capital Budgeting• Ideally, businesses should pursue all projects

and opportunities that enhance shareholder value. However, because the amount of capital available at any given time for new projects is limited, management needs to use capital budgeting techniques to determine which projects will yield the most return over an applicable period of time.

• Valuation refers to the process of determining the real worth of a proposal to the firm.

• Investment is made when a firm spends some of its funds for the establishment of a project. By doing so, the opportunity to use the same funds in other possible project is lost.– Initial investment – amount that has been

devoted to a project until it generates cash inflows from operations

– Later investment – expenditures made after the first cash inflow.

Objectives of Capital Budgeting• Establishing priorities• Cash planning• Construction planning• Eliminating duplication• Revising plans

Capital Budgeting System• Preparation and submission of budget

requests• Approval of budget• Request for appropriation• Submission of progress reports• Post approval reviews

• Budget Requests are those made to include in the corporate budget capital projects which are felt to be desirable by those in the lower organizational levels.

The budget request contains the following:1. Project Title;2. Cost, including estimates on;• Fixed capital• Working capital• Non-operating outlays• Others, including opportunity cost;

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3. Priority rating of the project;4. Profitability of the project;5. Timing or the ability to adhere to a construction

schedule;6. Financing method;7. Project classification; and8. Project narrative

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• Steps for the Approval of the Budget1. Budget requests are forwarded to top management;2. Top management decides which projects to

recommend to the board of directors;3. Top management sends recommendations to the

board of directors;4. The board of directors approves or disapproves the

recommendations; and5. Top management informs projects sponsors of the

action taken on their projects.

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The appropriations request usually contains the following:The appropriations request usually contains the following:1.1.The request and authority section The request and authority section – this serves to identify the – this serves to identify the originator and the project;originator and the project;2.2.The narrative section The narrative section – this details the requesting entity’s – this details the requesting entity’s justification for undertaking the proposal. justification for undertaking the proposal. •Proposal;Proposal;•Objectives;Objectives;•Conceptual framework;Conceptual framework;•Alternatives; andAlternatives; and•Sensitivity and riskSensitivity and risk

3.3.Supporting documentation sectionSupporting documentation section – this contains cost estimates – this contains cost estimates and the results of market studies and financial analysis.and the results of market studies and financial analysis.

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Progress Reports are submitted at regular intervals for the following purposes:

1.to review the accuracy of the expenditure forecasts;

2.to provide updated expenditures forecasts; and3.to verify the assumptions and economics

underlying the acceptance of individual projects.

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Post approval reviews are required to satisfy the following objectives:

1.to provide management with a standard method of evaluating the abilities and judgement of project sponsors;

2.to identify errors or patterns of error in judgement which can be avoided in future similar situations; and

3.to help ensure that the quality and accuracy of information attains the highest feasible standards.

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Evaluation of Proposed Capital Expenditures

• Urgency• Repairs• Credit• Non-Economic Factors• Investment worth• Risk involved

Methods of Economic Valuation• Payback Method• Average Rate of Return Method• Discounted Cash Flow Method

SampleAcquisition Cost 10,000,000

Economic Life 10 years

Salvage Value 100,000

Earnings and Costs per year

Income 5,000,000

Expenses (2,000,000)

NIBTD 3,000,000

Less: Depreciation (Straight Line) (1,000,000)

NIBT 2,000,000

Less: Income Tax (620,000)

Average Net Annual Earnings 1,380,000

*Cash Inflows per year = Net Earnings + Depreciation = 2,380,000

MEANING OF RISK, UNCERTAINTY AND SENSITIVITYMEANING OF RISK, UNCERTAINTY AND SENSITIVITYRisk is defined as the uncertainty concerning loss. Uncertainty, as a term is synonymous to risk, and as such, they will be used interchangeably in the discussions that will follow. Uncertainty and risk both refer to variations of actual values from average or expected values. The variations referred to in risks is caused by chance, while the variations referred to in uncertainty is caused by errors in estimating.Sensitivity refers to the effect on investment of changes in some factors, which were not previously determined with certainty.

FACTORS AFFECTING RISKFACTORS AFFECTING RISKThere are four primary factors involved in the evaluation of risks pertaining to capital expenditures. These are the following: (1) possible inaccuracy of the figures used in the evaluation; (2) type of business involved; (3) type of physical plant and equipment involved; and (4) the length of time that must pass before all the conditions of the evaluation become fulfilled. Estimates could be wrong or inaccurate at times. Accuracy, however, depends on how the figures were obtained. Estimates can be made either by scientific methods or by plain guesswork.Every type of business has its own degree of risk that is peculiar to itself. The demand for foo, for instance, is more stable than the demand for specialized consumer items like hair dyes. More risk is involved in the operations of a new venture than a business with a successful record of past performance.

Physical plants and equipment are also subject to risks. Some may become obsolete before their economic life expires. The demand for special equipment like that for DVD players, may diminish without warning.

Estimates involving longer periods are usually more prone to inaccuracies than those involving shorter periods. This is true because, most often, changes in the environment happen sooner than expected..

SENSITIVITY ANALYSISSENSITIVITY ANALYSISSensitivity analysis is applicable to capital expenditures Sensitivity analysis is applicable to capital expenditures involving the purchase or construction of a plant. It is useful involving the purchase or construction of a plant. It is useful for management to know the expected returns that will be for management to know the expected returns that will be generated by the various capacity utilization in the generated by the various capacity utilization in the operation of the plant. operation of the plant.