3.

1 Capital Expenditure/Capital Budgeting

3.2 Types of Capital Expenditure Decision
3.3 Capital Expenditure Control
3.4 Capital Expenditure Control Mechanisms
3.5 Tools and Techniques of Capital Expenditure Control
3.6 Performance Index
3.7 Technical Performance Measurement
3.8 Post Completion Audit
3.1 Capital Expenditure / Capital Budgeting:
A) Concept
The expenditures which generate revenue or income is called capital expenditure.
Capital expenditure incurred either for buying permanent assets or for improving their
exiting working capacity.
B) Meaning:
“Capital Budgeting Decisions involves the exchange of present expenditures for future
benefit which is the distinctive feature capital expenditure situation”.
“Capital budgeting means any investment involves commitment of funds with the
expectations of earnings a satisfactory returns on these investments over a period of time
in future”.
C) Definitions:
1) Charles T Horngreen :
“Capital budgeting is long term planning for making and financing proposed capital
outlays.”
2) Richard and Green:
“Capital budgeting as acquiring inputs with long run return.”
3) Lynch:
“Capital budgeting consists in planning development of available capital for the
purpose of maximising the long-term profitability of the concern.”
3.1 Capital Expenditure / Capital Budgeting:
E) Need of Capital Expenditure:

Long-Term Irreversible Effect On Future

Risk Element
Implications Decisions Cost Structure

Bearing on Worth-
Depreciation
Competitive Cash Forecast Maximization of
Policy
Position Shareholders

Feasibility of
Cost Reduction Replacing Cost of Safety Long-Term Plans
Manual Work

Revenue
Expenditure
2.1 Capital Expenditure / Capital Budgeting:
E) Need of Capital Expenditure:
1) Long-Term Implications:
Because they affect the future profitability of the firm and the cost structure, capital
budgeting decisions have long-term implications for the firm. It influences the rate
and direction of firm’s growth.
2) Risk Element:
Long-term commitment of funds may also change the risk elements of the firm. If
adoption of an investment proposal increases firm’s average earnings but
simultaneously causes frequent fluctuations in its earnings the firm will become more
risky.
3) Irreversible Decisions:
The capital budgeting decisions are irreversible and the heavy amount invested
cannot be taken back without causing a substantial loss because it is very difficult to
find a market for the second-band capital goods, and their conversion into other uses
may not be financially feasible.
4) Effect On Company’s Future Cost Structure:
By taking a capital expenditure decision, a firm commits itself to a sizeable
amount of fixed costs in terms of labour, supervisor’s salary, insurance, rent of
the building and so on.
2.1 Capital Expenditure / Capital Budgeting:
E) Need of Capital Expenditure:
5) Bearing on Competitive Position of the Firm:
As the fixed assets represent, in a sense, true earning assets of the firm, the capital
investment in fixed assets decision has a bearing on the competitive position of the
firm.
6) Cash Forecast:
Capital investment requires substantially large amount of funds. This can only be
arranged by making determined efforts to ensure their availability at the right time.
7) Worth-Maximisation of Shareholders:
Long-term capital investment decision protects the interests of the shareholders and
of the enterprise because it avoids over-investment and underinvestment in fixed
assets.
8) Help in Depreciation Policy:
It assists in formulating a sound depreciation and assets replacement policy.
9) Cost Reduction:
It may be useful in considering methods of cost reduction as a cost reduction
campaign may necessitate the consideration of purchasing most up-to date and
modern equipment.
2.1 Capital Expenditure / Capital Budgeting:
E) Need of Capital Expenditure:
10) Feasibility of Replacing Manual Work:
The feasibility of replacing manual work by machinery may be seen from the
capital forecast by comparing the manual cost and the capital cost.

11) Cost of Safety:

The capital cost of improving working conditions or safety can be obtained through
capital expenditure forecasting.

12) Long-Term Plans:

It facilitates the management in making of the long-term plans and assists in the
formulation of general policy.

13) Revenue Expenditure:

It studies the impact of capital investment on the revenue expenditure of the firm
such as depreciation, insurance and other fixed assets.
2.1 Capital Expenditure / Capital Budgeting:
G) Capital Budgeting Process:

Planning / Idea Generation

Screening the Proposals

Selection of Proposals

Financing of the Project

Execution / Implementation

Evaluation
2.1 Capital Expenditure / Capital Budgeting:
G) Capital Budgeting Process:
1) Planning / Idea Generation:
The search for promising project ideas is the first step in capital budgeting process. In
other words, the planning phase of a firm's capital budgeting process is concerned
with articulation of its broad investment strategy and the generation and preliminary
search of project proposals.

2) Screening the Proposals:

In large organisations, a capital expenditure planning committee is established for
the screening of various proposals received by it from the heads of various
departments and the line officers of the company. The committee screens the
various proposals within the long-range policy-frame work of the organisation.

3) Selection:
Selection or rejection follows the analysis phase. If the project is worthwhile, after
using a wide range of evaluation techniques, which are divided into traditional /
non- discounted and modern/discounted. Selection and rejection of a project
depends on the technique used to evaluate and its rule of acceptance.
2.1 Capital Expenditure / Capital Budgeting:
G) Capital Budgeting Process:
4) Financing of the Project:
After the selection of the project, the next step is financing. Generally, the
amount required is known after the selection of the project. Under this phase
financing arrangements have to be made.

5) Execution / Implementation:
Planning of paper work and implementation is physically different in
implementing the selected project implementation of an industrial project
involves the stages, project and engineering designs, negotiations and
contracting, construction, training, and plant commissioning.

6) Evaluation:
Last but not the least important step in the capital budgeting process is an
evaluation of the programme after it has been fully implemented. Once the
project is converted from paper work to concrete work, then, there is need to
review the project.
2.2 Types of Capital Expenditure Decision:
The type of proposal affects its size and scope. Proposal types commonly include the
following types of requests. Certain of these types may sometimes be paired as either/or
choices in capital expenditure proposals. All seven types of proposals are explained as
follows :
Acquiring New
Equipment

Upgrading
Strategic
Existing
Investments
Equipment

Replacing
Acquiring
Existing
Capital Assets
Equipment

Expansion of
Funding New
Existing
Programs
Programs
2.2 Types of Capital Expenditure Decision:
1) Acquiring New Equipment:
The reason why new equipment is needed must be clearly stated. The acquisition
cost must be a reasonable figure that contains all appropriate specifications. The
number of years of useful life that can be reasonably expected from the equipment
is also an important assumption.
2) Upgrading Existing Equipment:
The reason why an upgrade is necessary must be clearly stated. What is the impact?
What will the outcomes be from the upgrade? The upgrade costs must be a
reasonable figure that also contains all appropriate specifications. Will the upgrade
extend the useful life of the equipment, or if so, by how long?
3) Replacing Existing Equipment with New Equipment:
Capital expenditure involves the replacement of an old machine by a new one. The
replacement becomes necessary due to wear and tear or due to obsolescence. It
results in more production, better quality production and reduction in operating
costs.
4) Funding New Programs:
Here the investments are made in a new line of production. Such investments
are exposed to the greater degree of business risk due to the non-familiarity of
the production and sale area.
2.2 Types of Capital Expenditure Decision:
5) Funding Expansion of Existing Programs:
The investments are made in the known areas of activity as it involves lesser
business risk as compared to diversification, however, a bit greater risk than
replacement expenditure. A proposal for expansion of an existing program is
generally easier to prepare than a proposal for a new program.

6) Acquiring Capital Assets for Future Use:

This type of proposal may be the most difficult to accomplish. Capital expenditures
for future long-term use are often postponed by decision makers in cash-strapped
organization who first fulfill immediate demands for funding.

7) Strategic Investments:
These investments indirectly contribute to the revenues. Such investments may be
of following nature:
a) Investments in plant services like material handling, storing facilities etc.
b) Investments in personal services like investments for provision of canteen,
parking area, office air-conditioning etc.
c) Huge expenditure on advertisement campaign
d) Expenditure on marketing of securities etc.
2.4 Capital Expenditure Control Mechanisms:
Following are the Capital Expenditure Control Mechanisms:
1) Pre-sanction:
In this type of control one needs to take prior permission from the higher authority
before proceeding for the actual expenditure. Higher authority will look after the
need and feasibility of the expenditure and accordingly issue permission or deny
the expenditure.
2) Operational:
In operational control an individual or group is having the
responsibility of the operations. It involves rewarding favorable
expenditure and penalizing the unfavorable ones.
3) Post-sanction Control of Capital Expenditure:
In post sanctioned Capital Expenditure depending on the need
and demand of the situation expenditure should be made and
after the expenditure authority should seek permission from
the higher authorities about the incurred expenditure.
2.5 Tools and Techniques of Capital Expenditure Control:
For making a rational decision regarding the capital investment proposals, the decision maker
needs some techniques to convert the cash outflows and cash inflows of a project into
meaningful yardsticks, which can measure the economic worthiness of projects. A project is
worth pursuing if it increases the value of the company viable proposal drains the resources of
an enterprise and may eventually lead to bankruptcy. There are different kinds of techniques
that are used for capital budgeting. The most important and commonly used techniques are:

Capital Budgeting
Techniques

Traditional Modern
Methods Methods

Average Rate of Pay Back Period Net Present Internal Rate of Profitability
Return (ARR) Value (NPV) Return (IRR) Index (PI)
2.5 Tools and Techniques of Capital Expenditure Control:
Traditional Methods /Non- Discounting Techniques :
There are different types of capital budgeting techniques. They have to be applied
according to size of the organization, work processes, requirements of the business etc.
1) Average Rate of Return (ARR):
The average rate of return (ARR) method is traditional technique / method of
investment decision or capital budgeting. This is a method of evaluating proposed
capital investment.
A) Meaning:
The ARR is the ratio of the average after tax profit divided by the average
investment. It is also known as accounting rate of return method. It is based upon
accounting information rather than cash flow. There are a number of alternative
methods for calculating the ARR.
B) Formula :
The most common usage of it can be given as follows:
ARR= Average Annual Profits After Taxes/Average Investment*100
2.5 Tools and Techniques of Capital Expenditure Control:
Traditional Methods /Non- Discounting Techniques :

2) Pay Back Method:

This is also a traditional method of capital budgeting. It is the simple and most widely
employed method. This is the quantitative method for appraising capital expenditure
decisions.

A) Meaning:
It is the number of years required to recover the original cash outlay invested in a
project. This method tells us about the period that will take for the cash benefits to
pay the original cost of an investment.

B) Computation :
The way of calculating the payback period is :

Pay Back Period: Initial Investment/Annual Cash Inflows

2.5 Tools and Techniques of Capital Expenditure Control:
Modern Methods /Discounted Cash Flow Methods :
1) Net Present Value Method (NPV) :
The NPV is the first technique of present value or discounted cash flow. NPV is the
summation of the present values of the cash proceeds in each year minus the
summation of present values of the net cash out flows in each year.

A) Meaning:
The NPV is the difference between the present value of future cash inflows and the
present value of the initial outlay, discounted at the firm’s cost of capital.

B) Formula:
Net present value = Present value of cash inflows-Cash outflows (Initial Investment)
2.5 Tools and Techniques of Capital Expenditure Control:
Modern Methods /Discounted Cash Flow Methods :
2) Internal Rate of Return (IRR):
A) Meaning:
The internal rate of return (IRR) is the discount rate that equates the NPV of an
investment opportunity with Rs. 0 (because the present value of cash inflows equals the
initial investment). It is the compound annual rate of return that the firm will earn if it
invests in the project and receives the given cash inflows.
Formula-

IRR= Cash flows / (1+r)i – initial Investment

2.5 Tools and Techniques of Capital Expenditure Control:
Modern Methods /Discounted Cash Flow Methods :
3) Profitability Index Method :
Profitability Index (PI) or Benefit-cost ratio (B/C) is similar to the NPV approach. PI
approach measures the present value of returns per rupee invested. It is observed in
shortcoming of NPV that being an absolute measure.

A) Meaning:
It is a relative measure and can be defined as the ratio which is obtained by dividing
the present value of future cash inflows by the present value of cash outlays.

B) Formula:

PI= Present Value of Cash Inflows/Cash Outflows (Initial Investment)

This method is also known as B/C ratio (Benefit/Cost Ratio) because numerator
measures benefits & denominator measures cost.
2.7 Technical Performance Measurement:
A) Meaning:
Technical Performance Measurement (TPM) involves a technique of predicting the
future value of a key technical performance parameter of the higher-level end product
under development based on current assessments of products lower in the system
structure. At the start of a program, TPMs define the planned progress of selected
technical parameters.

B) Parameters of TPM:
TPMs provide an assessment of key capability values in comparison with those
expected over time. TPM is an evolutionary Program Management and systems
engineering tool that builds on the three parameters of :
1) Earned Value Management (EVM)
2) Cost and schedule performance indicators and
3) The status of technical achievement.

By combining cost, schedule, and technical progress into one comprehensive

management tool, program managers are able to assess the progress of their entire
program
2.8 Post Completion Audit:
A) Meaning:
‘Audit’ is generally defined as ‘an examination of documents and results to find out
whether they are in the desired order’. Thus the PCA is an attempt at assessing the
actual profile of the given project in terms of results vis-a-vis the intended profile
besides focusing on whatever matters the senior management desires.
B) Definitions:
1) Murdick and Deming:
“It is a check on whether the planned benefits are being realised after the project
has been operating for some period of time.”

2) Kohler:
“It is an audit at some point after the occurrence of a transaction or a group of
transactions.”

3) Donald Istvan:
"It is a study to ascertain the actual performance results, to compare those results
with those predicted in the proposal, and to take action regarding any differences
between the two.”
4.1 Performance Evaluation of Projects:
Definitions of project:
A project can be defined as a non-routine, non-repetitive, one-off undertaking,
normally with discrete time, financial and technical performance goals. Harison
An organized unit dedicated to the attainment of goal- the successful completion of a
development project on time, within budget, in conformance with pre-determined
programme specifications. Encyclopedia of management
A project is any scheme or part of a scheme for investing resources which can be
reasonably analyzed and evaluated as an independent unit. Little & Mirrless

Project Characteristics:
Objectives
Life Cycle
Team Work
Complexity
Risk and Uncertainty
Control Mechanism
Change and Flexibility
4.1 Performance Evaluation of Projects:
A) Parameters for Performance Evaluation of Project:

Took Longer than Planned

Schedule Overrun

Started Ahead

Accelerated

Start / Finish Discrepancy

Start / Finish Variance

Start Compliance

Finish Compliance
4.1 Performance Evaluation of Projects:
A ) Parameters for Performance Evaluation of Project:
1) Took Longer than Planned:
An interesting check that not many project managers focus on is the number of
activities that took longer than planned. An activity may start, or finish as planned, but
due to a late start or finish still have a longer duration than planned. This is useful
insight for future planning.
2) Schedule Overrun:
Identifying which activities are delayed, and calculating the number of days of total
delay on each activity is useful in identifying poor planning during early execution. If
caught soon enough, the metric can help to identify how much acceleration is needed
to finish on time, or provide insight into exactly how delayed a project finish will be.
3) Started Ahead:
Evaluating performance should look at what is going wrong, but also note areas that are
going better than planned. Identifying activities that have started ahead of schedule (or
finished ahead of schedule) is another useful way to track performance and better
forecast.
4) Accelerated:
To find accelerated activities, look for any activity that started after its planned start
date, but finished before or on the planned finish date. This measure indicates
improving execution performance and also helps to pinpoint opportunities for future
acceleration.
4.1 Performance Evaluation of Projects:
A) Parameters for Performance Evaluation of Project:
5) Start / Finish Discrepancy:
Gain insight into probability of finishing on schedule by calculating the variance
between total days started early and total days started late. The smaller the number
the better chance one has of finishing as planned.
6) Start / Finish Variance:
This calculation is similar to discrepancy but on an activity level. Look at the number of
days’ variance between the planned start or finish date and the actual start date or
finish date of activities. This will give a good indication of poorly performing areas of
the schedule.
7) Start Compliance:
Looking at activity start compliance, a measure of how many activities started on time
relative to a given baseline, helps to measures the knock-on effect of previous delays. If
start compliance is low, then few activities are able to start on time due to their
predecessors causing delay.
8) Finish Compliance:
Conversely, finish compliance, a measure of how many activities finished on time
relative to a given baseline, gives an indication of how well the project is performing.
Plotting this across time, to look at finish compliance on a per period basis, provides
insight into overall project performance and helps in identify performance trends.
4.1 Performance Evaluation of Projects:
B) Project Control Process:
Control is the process of comparing actual performance against standard
(Budgeted) performance to identify deviations, evaluate possible alternative
courses of actions, and take appropriate corrective action. The project control steps
for measuring and evaluating project performance are presented below.

Step 1: Setting Base Line Plan

Step 2: Measuring Progress

and Performance

Step 3: Comparing Plan

against Actual

Step 4: Taking Action

4.1 Performance Evaluation of Projects:
B) Project Control Process:
Step 1: Setting Base Line Plan:
The baseline plan provides us with the elements for measuring performance. The
baseline is derived from the cost and duration information found in the work
breakdown structure (WBS) database and time-sequence data from the network and
resource scheduling decisions. From the WBS the project resource schedule is used to
time-phase all work, resources, and budgets into a baseline plan. The baseline
process, while a key to project control, is often misunderstood. A baseline is defined as
the original plan for a project, a work package, or an activity, plus or minus approved
changes. A modifier (Project Budget Estimate schedule baseline, performance
measurement baseline) is usually included. A baseline provides the "ruler" that a
project can be evaluated with. Baseline changes are significant events and should not
be made without consideration of their impact.
Step 2: Measuring Progress and Performance:
Time and budgets are quantitative measures of performance that readily fit into the
integrated information system. Qualitative measures such as meeting customer
technical specifications and product function are most frequently determined by on-
site inspection or actual use. This chapter is limited to quantitative measures of time
and budget. Measurement of time performance is relatively easy and obvious.
4.1 Performance Evaluation of Projects:
B) Project Control Process:
Step 3: Comparing Plan against Actual:
Because plans seldom materialize as expected, it becomes imperative to
measure deviations from plan to determine if action is necessary. Periodic
monitoring and measuring the status of the project allow for comparisons of
actual versus expected plans. It is crucial that the timing of status reports be
frequent enough to allow for early detection of variations from plan and
early correction of causes. Usually status reports should take place every one
to four weeks to be useful and allow for proactive correction.

Step 4: Taking Action:

If deviations from plans are significant, corrective action will be needed to
bring the project back in line with the original or revised plan. In some cases,
conditions or scope can change, which, in turn, will require a change in the in
base line plan to recognize new information.
4.1 Performance Evaluation of Projects:
C) Methods of Variance Analysis:
Control is one of the most neglected areas of project management. Unfortunately, it is
not uncommon to find resistance to control processes. In essence, those who minimize
the importance of control are passing up a great opportunity to be effective managers
and, perhaps, allow the organization to gain a competitive edge. Neglecting control in
organizations with multiple projects is even more serious. For effective control, the
project manager needs a single information system to collect data and report progress
on cost, schedule, and specifications. Generally the method for measuring
accomplishments centers on two key computations:
1) Comparing earned value with the expected schedule value.
2) Comparing earned value with the actual costs.
These comparisons can be made at the project level or down to the cost account level.
Project status can be determined for the latest period, all periods to date, and
estimated to the end of the project. Assessing the current status of a project using the
earned value cost/schedule system requires three data elements—planned cost of the
work scheduled (PV), budgeted cost of the work completed (EV), and actual cost of the
work completed (AC). From these data the schedule variance (SV) and cost variance
(CV) are computed each reporting period. A positive variance indicates a desirable
condition, while a negative variance suggests problem; or changes that have taken
place.