Capital Expenditure Decisions

CAPITAL EXPENDITURE DECISIONS
What Is Capital Budgeting?

Capital budgeting is the process a business undertakes to evaluate potential major
projects or investments. Construction of a new plant or a big investment in an
outside venture are examples of projects that would require capital budgeting before
they are approved or rejected.
As part of capital budgeting, a company might assess a prospective project's

lifetime cash inflows and outflows to determine whether the potential returns that
would be generated meet a sufficient target benchmark. The capital budgeting
process is also known as investment appraisal.
What are the principles of capital budgeting?

The five principles are; (1) decisions are based on cash flows, not accounting
income
(2) cash flows are based on opportunity cost
(3) The timing of cash flows are important
(4) cash flows are analyzed on an after tax basis
(5) financing costs are reflected on project's required rate of return.
Principles of Capital Budgeting
Capital budgeting typically adopts the following principles:
Decisions are based on cash flows, not accounting concepts such as net income;
the timing of cash flows is critical;
Cash flows are based on opportunity costs. A comparison is made between the
incremental cash flows that occur with investment and without the investment;
Cash flows are analyzed on an after-tax basis. Taxes have to be fully reflected
in capital budgeting decisions;
The financing costs are ignored. Financing costs are already reflected in the
required rate of return and therefore including them again in the cash flows and
the discount rate would lead to double counting; and
The capital budgeting cash flows are not the same as accounting net income.
Nature of Capital Budgeting:
Capital budgeting is the process of making investment decisions in capital
expenditures. A capital expenditure may be defined as an expenditure the
benefits of which are expected to be received over period of time exceeding one
year.
The main characteristic of a capital expenditure is that the expenditure is
incurred at one point of time whereas benefits of the expenditure are realized at
different points of time in future. In simple language we may say that a capital
expenditure is an expenditure incurred for acquiring or improving the fixed
assets, the benefits of which are expected to be received over a number of years
in future.
The capital budgeting process consists of five steps:
1.Identify and evaluate potential opportunities
The process begins by exploring available opportunities. For any given initiative, a
company will probably have multiple options to consider. For example, if a company
is seeking to expand its warehousing facilities, it might choose between adding on to
its current building or purchasing a larger space in a new location. As such, each
option must be evaluated to see what makes the most financial and logistical sense.
Once the most feasible opportunity is identified, a company should determine the
right time to pursue it, keeping in mind factors such as business need and upfront
costs.
2.Estimate operating and implementation costs
The next step involves estimating how much it will cost to bring the project to fruition.
This process may require both internal and external research. If a company is
looking to upgrade its computer equipment, for instance, it might ask its IT
department how much it would cost to buy new memory for its existing machines
while simultaneously pricing out the cost of new computers from an outside source.
The company should then attempt to further narrow down the cost of implementing
whichever option it chooses.
3.Estimate cash flow or benefit
Now we determine how much cash flow the project in question is expected to
generate. One way to arrive at this figure is to review data on similar projects that
have proved successful in the past. If the project won't directly generate cash flow,
such as the upgrading of computer equipment for more efficient operations, the
company must do its best to assign an estimated cost savings or benefit to see if the
initiative makes sense financially.
4.Assess risk
This step involves estimating the risk associated with the project, including the
amount of money the company stands to lose if the project fails or can't produce its
previously anticipated results. Once a degree of risk is determined, the company can
evaluate it against its estimated cash flow or benefit to see if it makes sense to
pursue implementation.
5.Implement
If a company chooses to move forward with a project, it will need an implementation

plan. The plan should include a means of paying for the project at hand, a method
for tracking costs, and a process for recording cash flows or benefits the project
generates. The implementation plan should also include a timeline with key project
milestones, including an end date if applicable.
Capital Budgeting Techniques

The Capital Budgeting Techniques are employed to evaluate the viability
of long-term investments. The capital budgeting decisions are one of the
critical financial decisions that relate to the selection of investment proposal
or the course of action that will yield benefits in the future over the lifetime
of the project.
Since the capital budgeting is related to the long-term investments whose

returns will be fetched in the future, certain traditional and modern capital
budgeting techniques are employed by the firm to judge the feasibility of
these projects.
The traditional method relies on the non-discounting criteria that do not

consider the time value of money, whereas the modern method includes
the discounting criteria where the time value of money is taken into the
consideration.
CAPITAL BUDGETING TECHNIQUES
Traditional methods
The traditional methods comprise of the following evaluation techniques:
1. Payback Period Method

2. Average Rate of Return or Accounting Rate of Return Method
Modern Methods
The modern methods comprise of the following evaluation techniques:
1. Net Present Value Method

2. Internal Rate of Return
3. Modified Internal Rate of Return
4. Profitability Index
The common thing about both these methods (Traditional and Modern) is that
these are based on the cash inflows and the outflows of the project.
Concept And Measurement Of Cost Of Capital

The cost of capital of a firm is the minimum rate of return expected by its
investors. It is the weighted average cost of various sources of finance used by
the firm. The capital used may be debt, preference shares, retained earnings and
equity shares.
v The decision to invest in particular project depends on cost of capital or cut

off rate of the firm,.

To achieve the objective of wealth maximization, a firm must earn a rate of
v
return more than its cost of capital.

v
Higher the risk involved in the firm, higher is the cost of capital.
Concept And Measurement Of Cost Of Capital
The cost of capital of a firm is the minimum rate of return expected by its
investors. It is the weighted average cost of various sources of finance used by
the firm. The capital used may be debt, preference shares, retained earnings and
equity shares.
The decision to invest in particular project depends on cost of capital or cut off

rate of the firm,.

To achieve the objective of wealth maximization, a firm must earn a rate of

return more than its cost of capital.

Higher the risk involved in the firm, higher is the cost of capital.

Capital Expenditure Decisions

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CAPITAL EXPENDITURE DECISIONS

What Is Capital Budgeting?

As part of capital budgeting, a company might assess a prospective project's

What are the principles of capital budgeting?

The capital budgeting process consists of five steps:

1.Identify and evaluate potential opportunities

2.Estimate operating and implementation costs

3.Estimate cash flow or benefit

If a company chooses to move forward with a project, it will need an implementation

Capital Budgeting Techniques

Since the capital budgeting is related to the long-term investments whose

The traditional method relies on the non-discounting criteria that do not

1. Payback Period Method

1. Net Present Value Method

off rate of the firm,.

return more than its cost of capital.

rate of the firm,.

return more than its cost of capital.

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