Chapter 11

Capital Expenditures

Omar Maguiña Rivero

Learning Objectives

After studying this chapter, the student will be able

to understand the process for planning and

controlling capital expenditures.

Omar Maguiña Rivero

Capital Expenditure Defined

A capital expenditure is the use of funds (e.g., cash) to obtain operational assets that will:

a. Help earn future revenues or

b. Reduce future costs

Typically, capital expenditure projects involve large amounts of cash, other resources, and debt that are tied up for relatively long periods of time.

Omar Maguiña Rivero

Characteristics of a Capital Expenditure Budget Directly related to a company’s operating

assets, especially land, equipment, and other operational assets and cash.

Capital expenditures are usually classified as:

a. Major capital additions projects

b. Minor or small capital expenditures

Omar Maguiña Rivero

Characteristics of a Capital Expenditure Budget (cont.) The time dimensions of a capital expenditures

budget must be consistent with the comprehensive profit plan.

Capital expenditure budget must include:

a. A strategic (long-term) capital expenditure budget

b. A tactical (short-term) capital expenditure budget

Omar Maguiña Rivero

Project Orientation in the Capital Expenditure Budget

Major projects are usually named and

numbered. Typically, they are separately

analyzed, planned, approve or rejected,

completed and controlled.

Omar Maguiña Rivero

• Importance of Project-Related Information

EXTERNAL INTERNAL

Financial Market and Economic Trends

Cash Outflow Cash Inflow

Nonfinancial Government Regulation Technical Advancements

Operating Volumes Productivity Impact

Omar Maguiña Rivero

Time Dimensions in the Capital Expenditure Budget

The capital expenditure budget includes three time dimensions:

a. A time dimension required by a particular project that extends the farthest into the future.

b. A time dimension in conformity with the strategic long-range profit plan

c. A time dimension consistent with the short-range profit plan.

Omar Maguiña Rivero

Benefits of a Capital Expenditure Budget

Enable executive management to plan the amount of resources that should be invested in capital additions to satisfy customer demands, meet competitive demands, and ensure growth.

They also help avoid:

a. Idle Operating capacity

b. Excess capacity

c. Invest in capacity that will earn less than an adequate return on the funds invested.

Omar Maguiña Rivero

Responsibilities for Developing the Capital Expenditure Budget

For major capital expenditures, procedures should be established to ensure appropriate analysis and evaluation.

Procedures should require the originator to submit in writing including:

1. A description of the proposal

2. Reasons for the recommendations

3. Sources of relevant data

4. Advantages and disadvantages of the proposal

5. Recommended starting and completion dates

Omar Maguiña Rivero

• Capital Expenditure Decisions

Capital budget decision about alternatives should

usually be made on the investment worth of each

alternative. Basically, investment worth is profit

divided by investment.

Omar Maguiña Rivero

• A process for Planning and Controlling Capital Expenditures

Omar Maguiña Rivero

Methods of Measuring the Economic Value of a Capital Expenditure

Discounted Cash Flow (DCF) Methods

Net Present Value

Internal rate of Return

Short and Simple Methods

Payback

Accounting Rate of Return

Omar Maguiña Rivero

The Role of Judgment

In decision making, management must guard against

accepting a quantitative expression as being infallible

and thus be lulled into a false sense of confidence.

The role of management judgment is very important

despite the precise mathematical results obtained

from the various methods of measuring investment

worth. Omar Maguiña Rivero

Controlling Major Capital Expenditures

Elements of current control:

1. Authorization to star a project, including the appropriation of funds, even though the project was included in the annual profit plan.

2. Accumulating data on cost, work progress, and cumulative expenditures on each project in process.

3. A periodic capital expenditure status report that shows for each project such items as the following

Omar Maguiña Rivero

Controlling Major Capital Expenditures (cont.)

3. A periodic capital expenditure status report that shows for each project such items as the following:

Costs ( Amount budgeted, expenditure to date, outstanding commitments, amount unexpected per budget, estimated cost to complete project, Indicated over expenditure or under expenditure).

Progress report ( Date started, date originally schedule for completion, estimated days needed to complete project, estimate date of completion, percentage completed to date – cost and time.

Comments for top management (Quality of work, unexpected circumstances).

Omar Maguiña Rivero

Controlling Minor Capital Expenditures

This capital expenditures are usually provided for in a “blanket” appropriation for each responsibility center.

Omar Maguiña Rivero

AMOUNT APPROVAL REQUIRED

Up to $1,000 Center Management

$1,001 to $3,000 Plant Manager

$3,001 to $10,000 Vice-president in charge of manufacturing

Over $10,001 President