receive a satisfactory return (increase in revenue or reduction in costs) over an extended period of time. Example: Purchase of equipment for expansion, replacement of old equipment General Characteristics of Capital Investment Decisions As to Cost – usually involves large expenditure of resources, relative to business size As to Commitment – usually funds invested are tied up for a lone period of time. As to Flexibility – usually more difficult to reverse than short-term decisions As to Risk – usually involves so much risks and uncertainties due to operational and economic changes over an extended period of time Capital Budgeting
It is the process by which management identifies,
evaluates and makes decision on capital investment projects of an organization. It is the process of planning expenditures for assets, the return on which are expected to continue beyond one year period. Capital Budgeting Techniques 2 Methods of Capital Budgeting Techniques:
Non-discounted methods – methods that do not
consider the time value of money.
Discounted methods – methods that consider the time
value of money Non-discounting methods
1. Payback period method
2. Bail-out payback period 3. Accounting Rate of return 4. Payback reciprocal method. Payback Period Advantages of Payback 1. Payback is simple to understand and easy to compute. 2. Payback gives information about liquidity of the project. 3. It is good surrogate for risk. A quick or short payback period indicates a less risky project. Disadvantages of Payback 1. Payback does not consider the time value of money. All cash received during the payback period is assumed to be equal value of in analyzing the project. 2. It gives more emphasis on liquidity rather than on profitability of the project. In other words, more emphasis is given on return of investment rather than return on investment. 3. It does not consider the salvage value of project. 4. It ignores cash flows that may occur after the payback period. Bail-out Payback Period
A modified payback period method wherein cash
recoveries include the estimated salvage value at the end of each year of the project life. Accounting Rate of Return (ARR)
Investment may be based on original or average
investment. Industrial Engineering Method
-Based on the relationship between inputs and
outputs in physical forms; engineering estimates indicate what and how much cost should be. Account Analysis Method
-Each account is classified as either fixed or
variable based on experience and judgment of accounting ad other qualified personnel in the organization. Conference Method
-Costs are classified based on opinions from
various company departments such as purchasing, process engineering, manufacturing, employee relations and so on. Correlation Analysis - It is used to measure the strength of linear relationship between two or more variables. The correlation between two variables can be seen by drawing a scatter diagram:
- If the points seem to form a straight line, there is a
high correlation.
- If the points form a random pattern, there is a low
correlation or no correlation at all. Coefficient of Correlation (r) - Measures the relative strength of linear relationship between 2 variables. The range of the coefficient “r” is from -1.0 to +1.0. - If r = -1.0, there is a perfect inverse linear relationship between 2 variables. - If r = 0, no linear relationship. - If r = +1.0, there is a perfect direct relationship between X and Y. Coefficient of Determination (r2) - It is the proportion of the total variation in Y that is explained or accounted for by the regression equation, regardless of whether the relationship between X and Y is direct or inverse. It is the measure of “goodness of fit” in the regression. The higher the r2, the more confidence one can have in the estimated cost formula. Balance Scorecard - It is an approach to performance measurement that combines traditional financial measures with non- financial measures.
There are four (4) perspective of balance scorecard.
learning curve. Examples: employee satisfaction, employee turnover, training and recreation. Internal Business Processes Perspective
- Measures showing key business processes
performance. Examples: manufacturing cycle efficiency, product quality, productivity measures, throughput Components of Balanced Scorecard Strategic Objectives – a statement of what strategy must achieve and what is critical to its success. Strategic Initiatives – key action programs required to achieve strategic objectives. Performance Measures – describe how success in achieving the strategy will be measured. Baseline Performance – the current level of performance measure. Targets – the level of performance or rate of improvement needed in the performance measure. -end-