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CAPITAL EXPENDITURE PROCESS

Capital expenditures are expenditures creating future benefits. A capital expenditure is incurred
when a business spends money either to buy fixed assets or to add to the value of an existing fixed
asset.
CAPEX are used by a company to acquire or upgrade physical assets such as equipment, property, or
industrial buildings.
COMPONENETS
 Acquiring fixed, and in some cases, intangible assets.
 Repairing an existing asset to improve its useful life.
 Upgrading an existing asset if it results in a superior fixture.
 Preparing an asset to be used in business.
 Restoring asset or adapting it to a new or different use.
 Starting or acquiring a new business.
Capital Budgeting
The capital budget relates to the question of capacity and strategic direction of the firm. It deals with
the evaluation of the alternate disposition of capital funds as well as the choice of the best capital
structure.
The basic characteristic of a capital expenditure (also referred as capital investment or capital
project or
just project) is that it typically involves a current outlay or current & future outlays of fund in the
expectation of a stream of benefits extending far into future. Capital expenditure represents the
growing edge of business.
Investment Criteria
To judge worth-wholeness of investment projects following criteria suggested
 Discounting Criteria
 Non-discounting Criteria
Discounting Criteria

 Net Present Value-NPV

 Benefit Cost Ratio-BCR (Profitability-Index)
 Internal Rate of Return-IRR

Non-discounting Criteria

 Payback period-PB
 Accounting rate of return-ARR

Net Present Value-NPV

The net present value (NPV) of a project is the sum of present values of all cash flows (positive as well as
negative) that are expected to occur over the life of the project.

Where;
  NPV= Net Present value
 CFt = Cash flow at the end of year t
 n=is the life of the project
 r=is the discount rate
 CFo= Initial Investment

Decision Rule for-NPV

The NPV presents the net benefit over and above the compensation for time and risk. Hence decision rule
associated with the NPV criterion is;

 Accept the project if the NPV is positive

 Reject the project if NPV is negative
 If the NPV=0; it is a matter of indifference. (accept or reject)

Properties of the NPV Rule

 NPV are additive.

 Intermediate Cash Flows are invested at the Cost of Capital.
 NPV calculations permits time varying discount rates.

Limitations of NPV

 The NPV is expressed in absolute terms rather than relative terms and hence does not factor in the
scale of investment.
 The NPV rule does not consider the life of the project. Hence, when mutually exclusive projects with
different lives are being considered, the NPV rule is biased in favour of the longer term project.

Benefit Cost Ratio-Profitability Index

BCR= PVB/I

Net Benefit Cost Ratio=BCR-1

Where;

 PVB=Present Value of Benefit

 I=Initial Investment

Rule

BCR Approach

 When BCR is greater then 1 then accept the proposal.

 When BCR is equal to 1 then the approach is indifferent.
 When BCR is less than 1 then the reject the proposal.

NBCR Approach

 When NBCR is greater than 0 then accept the project.

 When NBCR is equal to zero then the approach is indifferent.
 When NBCR is less than 0 then the project should be rejected.

Internal Rate of Return-IRR

The internal rate of return-IRR of a project is the discount rate which makes its NPV equal to zero. It is the
discount rate which equates the present value of future cash flows with the initial investments.
Where;

 Ct= net cashflow in time period t

 IRR=Internal rate of return
 r= discount rate
 CO = Total Initial investment Cost

IRR is the discount rate that equates the present value of the future net cash flows from an investment project
with the project’s initial cash outflow.

Drawbacks of IRR

 There are problems in using IRR when cash flows of the project are not conventional or when two or
more projects are being compared to determine which one is the best.
 In the first case it is difficult to define ‘what is IRR’ and in the second case IRR can be misleading.
 Further, IRR cannot distinguish between lending and borrowing.
 Finally, IRR is difficult to apply when short term interest rates differ from long-term interest rates.

Capital Expenditure Process

The capital expenditure process involves:

 Generation of investment proposals.

 Evaluation and selection of those proposals.
 Approval and control of capital expenditures.
 Post-completion audit of investment projects.

Generation of Investment Proposals

• Investment ideas can range from simple upgrades of equipment, replacing existing inefficient
equipment, through to plant expansions, new product development or corporate takeovers.
• Generation of good ideas for capital expenditure is better facilitated if a systematic means of
searching for and developing them exists.
• This may be assisted by financial incentives and bonuses for those who propose successful projects.

Evaluation and Selection of Investment Proposals

To evaluate a proposal, the following data should be considered:

• Brief description of the proposal.

• Statement as to why it is desirable or necessary.
• Estimate of the amount and timing of the cash outlays.
• Estimate of the amount and timing of the cash inflows.
• Estimate of when the proposal will come into operation.
• Estimate of the proposal’s economic life.
Approval and Control of Capital Expenditures

• Capital-expenditure budget maps out the estimated future capital expenditure on new and continuing
projects.
• CEB has the important role of setting administrative procedures to implement the project (project
timetable, procedures for controlling costs).
• Timing is important because project delays and cost over-runs will lower the NPV of a project, costing
shareholder wealth.

Post-completion Audit of Investment Projects

Highlights any cash flows that have deviated significantly from the budget and provides explanations where
possible.

Benefits of conducting an audit are as following;

• May improve quality of investment decisions.

• Provides information that will enable implementation of improvements in the project’s operating
performance.

• May result in the re-evaluation and possible abandonment of an unsuccessful project.