Capital expenditure planning and control

CAPITAL EXPENDITURE
PLANNING AND
CONTROL

Introduction
 Decisions regarding acquisition of fixed
assets and other long-term projects of the
company are critical to the future profitability
and success of the company.
 Such investment includes purchase of
equipment, acquisition of land and buildings,
introduction of new products and so on.

Introduction
 The importance of capital investments also lie in
the fact that large sums of money are normally
sunk into these investments and once decisions on
them are made, they are nearly always
irretrievable.
 Whereas the returns on these investments go into
the future and may be highly uncertain in some
cases, the expenditure on them is now.

Introduction
 The future cash flows have to be properly
estimated and this is the most difficult aspect of the
planning and evaluation process.
 Having estimated the future cash flows of each
capital investment available, will evaluate each
investment proposal using the appropriate
appraisal techniques.
 Each investment proposal should be assessed on
the basis of its ability to achieve the minimum
expected return by the providers of t he funds that
will be channeled to that proposal.

Capital Expenditure Planning and
Control
 Capital Expenditure planning and control is a
process of facilitating decisions covering
expenditure on long-term assets.
 Capital Expenditures – include all expenditures
on tangible and in some cases intangible assets
which are expected to produce benefits to the
firm over a period of time (not less than one
year.)
 Capital Expenditure Planning and Control is an
integral part of the corporate plan of an
organization

Capital Expenditure Planning and
Control
 The Capital Budgeting process includes:
a. Identification
b. Development
c. Evaluation
d. Authorization
e. Control

Identification of investment
opportunities
 Identification of investment proposals is the most
critical aspect of the investment process and
should be guided by the overall strategic
considerations of a firm.
 Once the investment proposal has been identified,
each potential idea should be developed into a
project and submitted for appraisal to determine
its viability and worthiness.

Identification of investment
opportunities
 A sound appraisal technique which should
maximize the shareholder’s wealth should be
used to measure the economic worth of the
projects.
 In this respect, there would be a need to
consider all cash flows, to determine the true
profitability of the project. This will involve the
development of cash flow estimates.

Developing Cash Flow
Estimation
 Estimation of cash flow is a difficult task because
the future is uncertain. Therefore, the risk
associated with cash flow should be handled
properly and taken into account in the decision
process as the estimation of cash flow requires
collection and analysis of all quantitative and
qualitative data.

Evaluation of the Net Benefits
 In selecting a method or methods of investment
evaluation, a company should take adequate
care to ensure that the criteria selected would
lead, to the net increase in the company’s
wealth, that is, its benefit exceeds its cost
adjusted for time value and risk.
 The evaluation criteria should also not
discriminate between investment proposals.
 Whatever criterion that is applied, it should be
capable of ranking projects correctly in terms of
profitability.

 In this particular case, the net present value
method (NPV) is theoretically recommended,
among others by experts as it has a true
measure of profitability. It ranks projects correctly
and is consistent with the wealth maximization
criterion.
 However, other methods in use apart from the
NPV are the payback period, the internal rate of
return (IRR), accounting rate of return (ARR) and
profitability index (PI).

 In the implementation of a sophisticated evaluation
system, the use of a minimum required rate of return
is necessary. This should be based on the riskiness
of cash flows of the investment proposal which are
considered to be normally influenced by the
following factors:
a. Price of raw materials and other inputs;
b. Price of products (selling price);
c. Product demand;
d. Government policies;
e. Technological changes;
f. Project life; and

Authorization to Spend
 There is no specific standard administration
procedure for approving investment proposal as
it differs from one company to another.
 When large sums of capital expenditure is
involved, the authority for the final approval may
rest with the Board or the top management which
may be the Chief Executive of the company.
 The approval authority may be delegated to the
junior management for certain types of
investment project involving small amounts.

Authorization to Spend
 Funds are usually appropriated for capital
expenditure from the capital budget after the final
selection of investment proposals.
 Top management are to ensure that funds are
spent in accordance with appropriations made in
the capital budget.
 Funds for the purpose of project implementation
should be spent only after approval has been
granted by the finance manager or any other
authorized person.

Control and Monitoring of Capital
Projects
 A capital project reporting system is required to
review and monitor the performance of
investment projects during and after completion.
 This will mean comparing the actual performance
with original estimates. It will require regular
reporting either monthly, quarterly or semi-
annually.
 The evaluation reports may among others
include information on expenditure to date, stage
of physical completion and approved and revised
total cost.

Control and Monitoring of Capital
Projects
 The reappraisal may also include consideration
of the comparison between actual and forecast
capital cost savings and rate of return. The
perceived advantages of reappraisal are:
a. Improvement in profitability by positioning the
project as per the original plan;
b. Ascertaining of errors in investment planning which
can be avoided in the future;
c. Guidance for future evaluation of projects; and
d. Generation of cost consciousness among the
project team.

Investment Appraisal
Techniques
 Investment decisions affect the value of the firm
and this will increase, if investments are
profitable and add to shareholder’s wealth.
 It is, therefore important to ensure that
investments are evaluated on the basis of criteria
which are compatible with the objective of the
shareholder’s wealth maximization.
 It is necessary to examine the different methods
of selecting investment in long-term assets, that
is, capital expenditure, to be able to determine
the most valid technique of evaluating an

Techniques
 A number of capital budgeting techniques are
used in practice. They are grouped into two
major categories:
1. Discounted Cash Flow (DCF) Techniques
a. Net Present Value (NPV)
b. Internal Rate of Return (IRR)
c. Profitability index (PI); and
d. Discounted payback period
2. Non- Discounted Cash Flow Techniques

Techniques
 It is important to emphasize that expenditure on
and benefits of an investment should be
measured in cash. In this respect, it is the cash
flow that is important and not the accounting
profit.
 However, it is assumed that the capital projects
opportunity cost of capital (rate of return) is
known.
 It is also assumed that the expenditure and
benefits of the investment are known with
certainty.

Techniques
1. Non- Discounted Cash Flow Techniques
a. Payback Period (PB); and
b. Accounting Rate of Return (ARR)
 In evaluating an investment, three steps are
involved:
a. Estimation of cash flows;
b. Estimation of the required rate of return (cost of
capital);
c. Application of a decision rule for making the choice

Non-Discounted Cash Flow
Techniques
 Payback period technique
 This technique shows the number of years over
which the investment would be recovered.
 It is the period usually expressed in years, in which
the cash outflows will equate the cash inflows from a
project.
 This technique measures projects on the basis of
the period over which the investment pays back
itself or the period of recovery of the initial
investment.
 The full recovery of the projects cash outflow would
be measured through the cash inflows.

Payback Period Technique
 This method pays attention to the shortness of
the project, that is, the shorter the period of
recovery of initial investment or capital outlay, the
more acceptable the project becomes.
 Where there is constant or uniform annual net
cash flows from a project, the payback period is
calculated thus:
 Payback Period = Initial Investment (Capital
Outlay)
Annual Net Cash Flow

 Decision rule
 If the payback period is calculated for a project is
less than the maximum or standard payback
period set by management, it would be accepted, if
not, it would be rejected.
 If the firm has to choose among two mutually
exclusive projects the project with shorter payback
period will be selected.

 Advantages of Payback Method
a. It is simple to calculate and better understood of all
the methods of capital budgeting.
b. It least exposes the firm to the problem of
uncertainty since it focuses on shortness of project
to pay back the initial outlay.
c. It is a fast screening technique especially for the
firms that have liquidity problems.

 Disadvantages of Payback Method
a. It does not take account of the cash inflows earned
after the payback period.
b. It does not take into account the time value of
money
c. It does not take into account the risks associated
with each project and the attitude of the company
to risk.

Accounting Rate of Return
 The accounting rate of return (ARR) technique is
derived from the concept of return on capital
employed (ROCE) which is also known as return
on investment (ROI).
 It uses accounting information provided by the
financial statements to measure the profitability
of an investment. It is calculated by dividing the
average after-tax-profit by the average book
value of the investment during its life.

 ARR = Average Income____ x 100%
Average Investment
 Decision Rule:
 The rule is to invest in all projects whose
accounting rate of return (ARR) are higher than the
company’s pre-determined minimum acceptable
rate
 Where mutually exclusive projects are concerned,
the rule is to accept the project with the highest
ARR

 Advantages of Accounting Rate of Return
 It is easy to calculate
 It is simple to understand and use
 It incorporates the entire stream of income in
calculating the project’s profitability.

 Disadvantages of Accounting Rate of Return
 It uses accounting profits in appraising the projects.
 The averaging of income ignores the time value of
money.
 It uses an arbitrary cut off yardstick
 It is an average concept and as such will hide the sizes
and timing of the individual cash flows.
 It does not take into consideration the risk associated
with each project as well as the attitude of the
management to risk.
 There is no unique definition for ARR. For instance
“average profit” may be profits after depreciation,
interest and tax. Initial investment could be initial

Discounted Cash Flow (DFC)
Techniques
 Net Present Value (NPV) Method
 is one of the discounted cash flow techniques that
recognizes the time value of money
 It is the net contribution of a project to its owners
wealth,
 It is the present value of future cash flows minus the
present value of the initial capital investment.
 All cash flows are discounted to their present values
using the required rate of return.

Net Present Value (NPV)
Method
 The formula for calculating NPV are as follows

Method
 Advantages of NPV
a. It recognizes the time value of money’
b. It uses all cash flows occurring over the entire life
of the project;
c. It measures in absolute terms (Peso/Dollar value)
the increase in wealth of the shareholders; and
d. It facilitates measuring of cash flows in terms of
present values. This implies that if the values of
separate assets are known, the firms value can
simply be found by adding their values. This is
called the value-additivity principle.

Method
 Disadvantages of NPV
a. It is more difficult to calculate than the payback
and the accounting rate of return; and
b. It relies heavily on the correct estimation of the
cost of capital, that is, where errors occur in the
cost of capital used for discounting, the decision
would be misleading.

Internal Rate of Return (IRR)
 The internal rate of return method is another
discounted cash flow technique which takes
account of the time value of money.
 It is also known as yield of a project, marginal
efficiency capital, rate of return over cost, time
adjusted rate of return and so on.
 It is defined as the cost of capital for which the
NPV of a project would be zero.

 It is a break-even point cost of capital. It is also
the cost of capital or discount rate that will
equate the cash inflows of a project with the
cash outflows of that project.
 The formula for calculating the IRR is:

 The formula shows that it is the same as that for
calculating NPV.
 The only difference is that in NPV method, the
required rate of return is assumed to be known
while in IRR method the required rate of return
has to be determined, hence, the result is
equated to zero.

 An alternative method to the above formula is the
trial and-error method. This is also know as
interpolation method.
 In this method, the discounting factor yielding a
positive NPV is improved to move towards negative
and a midway is discovered to arrive at zero. The
formula:

 Decision rule:
 Accept all projects whose IRR are greater than the
company’s cost of capital.
i.e. Accept if r > k
Reject if R < k
May accept or reject if r = K
Where r = internal rate of return and k = cost of
capital
If mutually exclusive projects are being considered
the rule is to accept the project that produces the
highest IRR.

 Advantages of IRR
a. It recognizes the time value of money
b. It considers all cash flows occurring over the entire
life of the project
c. It gives the same acceptance rule as the NPV
method
d. It is consistent with the stakeholders wealth
maximization objective.

 Disadvantages of IRR
a. It is more difficult to calculate than the other
methods.
b. It can give misleading and inconsistent results when
the NPV of a project does not decline with discount
rates.
c. In some cases, it fails to indicate a correct choice
between mutually exclusive projects.
d. Unlike in the case of NPV, the additivity principle
does not hold when IRR method is used – IRR
projects do not add
e. Sometimes, it yields multiple rates.

Profitability Index (PI)
Technique
 The profitability index (PI) method is another cash
flow technique.
 It is the ratio of the present value of cash inflows, at
the required rate of investment. It may be gross or
net that is, gross minus one.
1 +

Technique
 Decision rule
 Accept all projects whose PI is greater than 1
(one)
i.e. Accept if PI > 1
Reject if PI < 1

Technique
 Advantages of PI
b. It is a variation of the NPV method and requires
the same computation as in the NPV method
c. It is a relative measure of a project’s profitability
since the present value of cash inflows is divided
by the initial cash outflow.
d. It is generally consisted with the wealth
maximization principle

Technique
 Disadvantages of PI
a. It can only be used to choose projects under
simple, one period, capital constraint situations.
b. It does not work when mutually exclusive
projects or dependent projects are being
considered.

Discounted Payback Period
Technique (DPPT)
 This technique is an improvement over the
payback method.
 It is aimed at overcoming the problem of the
time value of money disadvantage of the
normal payback method, by incorporating into
its calculation, the discount factor.
 In the discounted payback period method, the
cash flows are discounted and used in the
calculation of the payback period.

Technique (DPPT)
 Advantages of Discounted Payback Period
Technique
b. It focuses on shortness of project to payback
the initial outlay
c. In addition to the fact that it recognizes the time
value of money it has all the advantages of the
payback method.

Technique (DPPT)
 Disadvantages of Discounted Payback Period
Technique
a. It does not take into account the cash inflows
earned after the payback period.
b. It does not take into account the risks
associated with each project and the attitude of
the company to risk
c. Except that it uses discounted cash flows, it has
all the disadvantages of payback method.

Capital expenditure planning and control

Capital expenditure planning and control

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