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CHAPTER 5

CAPITAL BUDGETING
CAPITAL BUDGETING
• Planning and control of capital expenditures, this activity is essential
because it provides a systematic evaluation of the firm’s alternatives.
• Is the planning process used to determine whether an organization's
long term investments such as new machinery, replacement of
machinery, new plants, new products, and research development
projects are worth the funding of cash through the firm's capitalization
structure (debt, equity or retained earnings). It is the process of
allocating resources for major capital, or investment, expenditures.
• One of the primary goals of capital budgeting investments is to increase
the value of the firm to the shareholders.
• Capital budgeting is important because it creates accountability and
measurability. Any business that seeks to invest its resources in a
project, without understanding the risks and returns involved, would be
held as irresponsible by its owners or shareholders. Furthermore, if a
business has no way of measuring the effectiveness of its investment
decisions, chances are that the business will have little chance of
surviving in the competitive marketplace.
BASIC TERMS IN CAPITAL BUDGETING

1. Capital Expenditures
2. Capital Budgeting
3. Valuation
4. Investments
CAPITAL EXPENDITURES
• Refers to substantial outlay of funds the purpose of which to
lower costs and increase net income for several years in the
future. It includes expenditures that tie up capital inflexibility
for long periods.
• Is the money a company spends to buy, maintain, or improve
its fixed assets, such as buildings, vehicles, equipment, or land.
• It is considered a capital expenditure when the asset is newly
purchased or when money is used towards extending the
useful life of an existing asset, such as repairing the roof.
CLASSES OF CAPITAL EXPENDITURES
• REPLACEMENT INVESTMENTS- refers to investments on replacement of worn-
out or obsolete facilities.
• EXPANSION INVESTMENTS-type of expenditure will provide additional facilities
to increase the production or distribution capabilities of the firm.
• PRODUCT-LINE OR NEW MARKET INVESTMENTS-refers to expenditures on new
products or new markets, and on improvement of old products with the
combined features of replacement and expansion investments.
• INVESTMENTS IN SAFETY AND/OR ENVIRONMENTAL PROJECTS-are
expenditures necessary to comply with government orders, labor agreements,
or insurance policy terms.
• STRATEGIC INVESTMENTS-are investments designed to accomplish the overall
objectives of the firm.
• OTHER INVESTMENTS- catch all the term includes office, buildings, parking lots,
executive aircraft.
VALUATION
• In finance, valuation is the process of determining the present
value (PV) of an asset. Valuations can be done on assets (for
example, investments in marketable securities such
as stocks, options, business enterprises, or intangible
assets such as patents and trademarks) or on liabilities
(e.g., bonds issued by a company). Valuations are needed for
many reasons such as investment analysis, capital
budgeting, merger and acquisition transactions, financial
reporting, taxable events to determine the proper tax liability,
and in litigation.
• When the proposal’s is real worth to the firm is determined.
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 the other project is lost.
• TWO FORMS OF INVESTMENTS:
1. INITIAL INVESTMENT-refers to the amount that has
been devoted to a project until it generates cash
inflows from operations.
2. LATER INVESTMENT-expenditures made after the first
cash inflow.
OBJECTIVES OF CAPITAL BUDGETING
A. Establishing priorities;
B. Cash planning;
C. Construction planning
D. Eliminating duplication; and
E. Revising plans.
CONSTRUCTION PLANNING
• The objective of construction planning is to minimize the period
expended for the construction or acquisition of a capital asset.

ELIMINATING DUPLICATION
• A centralized capital budgeting activity will help identify efforts
undertaken at various levels in a decentralized organization.
ESTABLISHING PRIORITIES

• The total number of opportunities available for investment


cannot be all accommodated by the firm. Capital budgeting will
help to solve this difficulty. This is possible because investment
priorities are established in capital budgeting.
CASH PLANNING
• The cash planning activities of the firm is to ensure the
availability of the funds that will sufficient to meet its cash
requirements, including those concerning the acquisition of
capital assets.
REVISING PLANS
• Changes the environmental factors may require
appropriate revisions in the authorization of
investment projects which include expected
profitability, construction cost, and the timing of
start-up, where coordination with related
activities is essential.
THE CAPITAL BUDGETING SYSTEM
Capital budgeting system is composed of the
following;
1. Preparation and submission of budget request.
2. Approval of budget
3. Request for appropriation
4. Submission of progress reports; and
5. Post approval reviews
BUDGET REQUEST
• 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:
a. Fixed capital
b. Working capital
c. Non-operating outlays
d. others, including opportunity cost;
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; and
8. Project narrative
APPROVAL OF THE BUDGET
• The approval of the budget is a process which requires the following steps:
1. Budget request 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; and
5. Top management informs projects sponsors of the action taken on their projects.
REQUEST FOR APPROPRIATION
• The next step undertaken is getting the appropriations request approved.
The officers and the managers of the corporation are usually given the
authority to approve appropriations request up to certain establish limits.
• Appropriations request contains the following:
1. THE REQUEST AND AUTHORITY SECTION-this serves to identify the
originator and the project;
2. THE NARRATIVE SECTION-this details the requesting entity’s justification
for undertaking the proposal.
a. Proposal
b. Objectives
c. Conceptual framework
d. Alternatives; and
e. Sensitivity and risk.
3. SUPPORTING DOCUMENTATION SECTION-this contains cost estimates and the results of
market studies and financial analysis.

SUBMISSION OF PROGRESS REPORTS


Progress reports are submitted at regular intervals for the
following purposes;
1. To review the accuracy of the expenditures forecasts;
2. To provide updated expenditures forecasts; and
3. To verify the assumptions and economics underlying the
acceptance of the individual projects.
POST APPROVAL REVIEWS

• Post approval reviews are required to satisfy the following


objectives:
1. To provide management with a standard method of evaluating
the abilities and judgment of project sponsors.
2. To identify errors or patterns of error in judgment which can
be avoided in the future similar situations; and
3. To help ensure that the quality and accuracy of information
attains the highest feasible standards.
EVALUATION OF PROPOSED CAPITAL EXPENDITURES
• Proposed capital expenditures should be scrutinized since they involve large outlays
of funds. A number of primary factors should be considered by management. These
are the following:
1. URGENCY- decisions should be made as quickly as possible for requirements that
are urgent.
2. REPAIRS- should consider the availability of the spare parts and maintenance
experts.
3. CREDIT- this factors should be considered in the sense that some credit terms
may be highly favorable to the company.
4. NON-ECONOMIC FACTORS- refer to social considerations, and other non-
economic persuasions and preferences.
5. INVESTMENT WORTH- refers to the economic evaluation of a certain proposal.
6. RISK INVOLVED- refers to the uncertainty of the expected return.
METHODS OF ECONOMIC EVALUATION
• A requirement that investment proposals should be analyzed and a
determination of their economic value to the firm should be made.
METHODS OF EVALUATING PROPOSALS:
1. THE PAYBACK METHOD
2. THE AVERAGE RATE RETURN METHODS
3. THE DISCOUNTED CASH FLOW METHODS
4. NET PRESENT VALUE METHOD
5. INTERNAL RATE OF RETURN METHOD