Capital Budgeting - Business Finance


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Capital Budgeting - Business Finance

  1. 1. Capital Expenditures – refers tosubstantial outlay of funds the purpose ofwhich is to lower costs and increase netincome for several years in the future.Classes of Capital Expenditures: • Replacement investments - investments on replacement of worn-out or obsolete facilities. • Expansion investments – this will provide additional facilities to increase the production and/ or distribution capabilities of the firm Basic Terms in Capital Budgeting 3
  2. 2. • Product-line or new market investments – expenditures on new products or new markets.• Investments in safety and/ or environmental projects – these are necessary to comply with government orders, labour agreements, or insurance policy terms.• Strategic Investments – these are designed to accomplish the overall objectives of the firm.• Other Investments – this includes office buildings, parking lots, executive aircraft. Basic Terms in Capital Budgeting 4
  3. 3. Capital Budgeting – is referred to as theplanning and control of capital expenditures.Valuation - is the process of estimatingwhat something is worth.Investment – this is made when a firmspends some of its funds for theestablishment of a project. Basic Terms in Capital Budgeting 5
  4. 4. Objectives of Capital Budgeting1. Establishing Priorities – investment priorities are established in capital budgeting2. Cash Planning – to ensure the availability of funds that will be sufficient to meet its cash requirements3. Construction Planning – to minimize the period expended for the construction or acquisition of a capital asset4. Eliminating Duplication – to minimize the duplication of efforts.5. Revising Plans – changes in environmental factors may require revisions in authorization of investment Objectives of Capital Budgeting 7
  5. 5. The Capital Budgeting System 1. Preparation and Submission of Budget Requests; 2. Approval of Budget; 3. Request for Appropriation; 4. Submission of Progress Reports; and 5. Post Approval Reviews The Capital Budgeting System 9
  6. 6. The Capital Budgeting System:Budget Requests• 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; The Capital Budgeting System 10
  7. 7. The Capital Budgeting System:Budget Requests 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 The Capital Budgeting System 11
  8. 8. The Capital Budgeting System:Approval of the Budget• 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. The Capital Budgeting System 12
  9. 9. The Capital Budgeting System: Request for AppropriationThe appropriations request usually 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. • Proposal; • Objectives; • Conceptual framework; • Alternatives; and • Sensitivity and risk3. Supporting documentation section – this contains cost estimates and the results of market studies and financial analysis. The Capital Budgeting System 13
  10. 10. The Capital Budgeting System:Submission of Progress Reports Progress Reports are submitted at regularintervals 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. The Capital Budgeting System 14
  11. 11. The Capital Budgeting System:Post Approval Reviews Post approval reviews are required to satisfy thefollowing 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; and3. to help ensure that the quality and accuracy of information attains the highest feasible standards. The Capital Budgeting System 15
  12. 12. Proposed capital expenditures should be scrutinized sincethey involve large outlay of funds. A number of primary factorsshould be considered by management. These are thefollowing:1. Urgency. Decisions should be made as quickly as possible for requirements that are urgent.2. Repairs. Management should consider the availability of spare parts and maintenance experts.3. Credit. This factor should be considered in the sense that some credit terms may be highly favorable to the company.4. Non-Economic Factors. These refer to social considerations and other non-economic persuasion and preferences.5. Investment Worth. This refers to the economic evaluation of a certain proposal.6. Risk Involved. This refers to the uncertainty of an expected return. Evaluation of Proposed Capital Expenditures 17
  13. 13. Methods of Economic Evaluation: The 19 Payback Method
  14. 14. The Disadvantages of Payback Method:1. it does not consider the time value of money;2. the accept-reject criterion is stated in terms of years rather than at a discount rate;3. the firm’s attention is focused on cash flow rather than on rate of return;4. careful projection of the timing of the investment outlays and the year-by-year projection of cash inflows over the entire life of the proposal are not encouraged; and5. the salvage value of the proposal is not considered. Methods of Economic Evaluation: The 20 Payback Method
  15. 15. Methods of Economic Evaluation: The 21 Average Rate of Return Methods
  16. 16. Methods of Economic Evaluation: The 22 Average Rate of Return Methods
  17. 17. DISCOUNTED CASH FLOW METHODS The time value of money is recognized under thediscounted cash flow methods. There are twoapproaches available: (1) The Net Present Value Method; and (2) The Internal Rate Of Return Method. Under these approaches all future values of aproposal are discounted and compared to thevalues of other proposals. The discounting factormakes these two methods preferred by users inevaluating capital expenditure proposals. Methods of Economic Evaluation: Discounted 23 Cash Flow Methods
  18. 18. Net Present Value Method Under this method, a desired rate of return is usedfor discounting purposes. The present value concept isapplied to the cash flows of a proposal and arediscounted at the desired rate of return for the periodsinvolved. NPV = PVCI – PVCOwhere NPV = net present value PVCI = discounted value of the anticipated cash inflows PVCO = discounted value of the anticipated cash outflows Methods of Economic Evaluation: Discounted 24 Cash Flow Methods
  19. 19. Methods of Economic Evaluation: Discounted 25 Cash Flow Methods
  20. 20. Internal Rate of Return Method Under the internal rate of return method, the discount rateis not given. Rather, it becomes the object of computation. Thediscount rate which will yield a net present value of zero or oneapproximating zero is the correct discount rate. This meansthat the present value of the cash inflows is equal to thepresent value of the cash outflows. The correct discount ratemay be determined by trial and error. a. NPV at 22% discount rate= PVCI–PVCO = ₱9,350,800–₱10,00,000 = -(₱649,200) b. NPV at 21% discount rate= PVCI–PVCO = ₱9,603,520–₱10,000,000 = -(₱396,480) c. NPV at 20% discount rate = PVCI–PVCO = ₱9,994,080–₱10,000,000 = -(₱5,920)
  21. 21. MEANING OF RISK, UNCERTAINTY ANDSENSITIVITY Risk is defined as the uncertainty concerning loss.Uncertainty, as a term is synonymous to risk, and assuch, they will be used interchangeably in thediscussions that will follow. Uncertainty and risk bothrefer to variations of actual values from average orexpected values. The variations referred to in risks iscaused by chance, while the variations referred to inuncertainty is caused by errors in estimating. Sensitivity refers to the effect on investment ofchanges in some factors, which were not previouslydetermined with certainty. Risk, Uncertainty and Sensitivity 28
  22. 22. FACTORS AFFECTING RISK There are four primary factors involved in the evaluationof risks pertaining to capital expenditures. These are thefollowing: (1) possible inaccuracy of the figures used in theevaluation; (2) type of business involved; (3) type of physicalplant and equipment involved; and (4) the length of time thatmust pass before all the conditions of the evaluation becomefulfilled. Estimates could be wrong or inaccurate at times.Accuracy, however, depends on how the figures wereobtained. Estimates can be made either by scientific methodsor by plain guesswork. Every type of business has its own degree of risk that ispeculiar to itself. The demand for foo, for instance, is morestable than the demand for specialized consumer items likehair dyes. More risk is involved in the operations of a newventure than a business with a successful record of pastperformance. Risk, Uncertainty and Sensitivity 29
  23. 23. Physical plants and equipment are also subject torisks. Some may become obsolete before theireconomic life expires. The demand for specialequipment like that for DVD players, may diminishwithout warning. Estimates involving longer periods are usually moreprone to inaccuracies than those involving shorterperiods. This is true because, most often, changes inthe environment happen sooner than expected. Risk, Uncertainty and Sensitivity 30
  24. 24. SENSITIVITY ANALYSIS Sensitivity analysis is applicable to capitalexpenditures involving the purchase or construction ofa plant. It is useful for management to know theexpected returns that will be generated by the variouscapacity utilization in the operation of the plant. Risk, Uncertainty and Sensitivity 31