FACULTY OF BUSINESS

ACADEMIC PROFESSIONAL SCHOOL OF MANAGEMENT

Course : Budget Administration

teacher : Aguirre Morales, Juan.

Issue : Capital Budget.

Cycle : III

Classroom : 508

Shift : Friday - Tomorrow

Members

1. Coronado Moreno, Kenyi.

2. López Ballena, Monica

3. Mace Angeles, Tony.

4. Montero Acaro, Graciela.

5. Samanamud Mendoza, Mayumi.

6. Vásquez Blas, Astrid.

New Chimbote – Peru

2014
 DEDICATION

We first dedicate our work to God who is the creator of all things, who has given
us strength to continue when we have been on the verge of falling; Likewise, to
our parents, to whom we owe our entire lives, we thank them for their love and
understanding.
 PRESENTATION

This work is aimed at all those people who would like to learn about capital
budgeting, from the peak of larger finances and, most importantly, we will
expand our cultural background on the subject.
 INDEX

DEDICATION...................................................................................................................2
PRESENTATION..............................................................................................................3
INDEX................................................................................................................................4
INTRODUCTION..............................................................................................................6
CAPITAL BUDGET..........................................................................................................6
1. Definition of budget................................................................................................6
2. Definition of capital.................................................................................................7
3. Definition of capital budget.....................................................................................7
4. Goals........................................................................................................................7
5. Characteristics of capital budgeting........................................................................8
6. Differences between capital budgeting and other budgets......................................8
7. Project classes..........................................................................................................8
—Replacement of equipment or buildings or Replacement...........................................9
— Projects: New products, expansion of existing products or Expansion.....................9
8. Benefits....................................................................................................................9
9. Capital Budgeting Process.....................................................................................10
10. Procedure for the Evaluation of the Capital Budget..........................................11
— Calculate the initial investment...............................................................................11
— Calculate Cash Flows..............................................................................................11
— Calculate salvage value............................................................................................11
11. Evaluation methods...........................................................................................12
— Refund technique.....................................................................................................13
— Accounting Rate of Return Technique....................................................................15
8,000.............................................................................................................................17
— Profitability Index Technique..................................................................................17
— Internal rate of return technique..............................................................................18
12. Techniques for evaluating risk in capital budgeting..........................................21
— Subjective system....................................................................................................21
— System of expected values.......................................................................................21
— Statistical systems....................................................................................................22
— Simulation................................................................................................................22
— Risk-adjusted discount rates....................................................................................23
 13. Budget for Capitalizable Disbursements and their Relationship with Cash
Flows.23
— Conventional cash flows..........................................................................................24
— Unconventional cash flows......................................................................................24
14. Planification and control....................................................................................24
15. Importance.........................................................................................................25
CONCLUSIONS..............................................................................................................26
BIBLIOGRAPHIC REFERENCES.................................................................................27
 INTRODUCTION

The capital budget is a valued list of projects that are presumed feasible for the
acquisition of new fixed assets, therefore the advisor must evaluate the
convenience of investing in industrial and commercial buildings, transportation
equipment, machinery, equipment, furniture and useful, etc.

The problem of fixed capital investment is essentially the determination of

whether the expected profits for a proposed project are sufficiently attractive to
warrant the investment of funds in that project. The investment is made on a
specific date, while the profits are spread over long periods in the future.

To analyze the suitability of investments through the study of the return on

capital, it is possible to use models such as IRR and NPV, which take into
consideration the market interest rate, allowing us to evaluate the opportunity
costs between one alternative or another.

The authors
CAPITAL BUDGET
1. Definition of budget
According to Flores Soria (2008), it is the detailed and quantified plan that serves as
a guide for the company's future activities in pursuit of maximizing its profits.

Furthermore, García Mendoza (1998) adds that a budget is a quantitative future

action plan that will help in decision-making and will also serve to evaluate the
decisions made. Due to the different meanings of the term capital, it will be
necessary to specify under what context it will be used when referring to the capital

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 budget.

2. Definition of capital
According to Flores Soria (2008), they are the relatively scarce non-human
resources of a productive company.

3. Definition of capital budget

For Pastor Paredes (2010), the planning process for disbursements on fixed assets,
whose estimated cash flows are long-term.

According to Almeida Hidalgo (2007), mentions that the Capital Budget is a tool
used for the planning process of expenses corresponding to those assets of the
company, whose economic benefits are expected to extend over periods greater
than one fiscal year.

The capital budget is a valued list of projects that are presumed feasible for the
acquisition of new fixed assets, that is, when a commercial company makes a
capital investment, it incurs a current cash outflow, expecting future benefits in
return. Typically, these benefits extend beyond one year into the future.

Some examples include investing in assets such as equipment, buildings, and land,
as well as introducing a new product, a new distribution system, or a new research
and development program.

4. Goals

According to the capital budget, its fundamental objective is the correct planning
and rational study of the factors involved in the decision to make investments in
different instruments in accordance with the expansion plans and progress in the
technological aspect as well as the plans. management of funds and their
availability.

By its nature, this budget aims to forecast and control the elements that form the
capital position, such as working capital, the effect that estimates will produce on
cash, banks, as well as on decision making, all of this. always referring to the
capital structure, or accessory issues such as the operating fund, that is, the capital
invested in assets such as plant, machinery and equipment and inventories.

The objectives of the capital budget are the following:

- Administrative control.

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 — Better cash management, maintaining balances at the lowest levels possible.
— Plan resources, for their best distribution.
— Decisions on acquisitions of operating assets. Capital invested in production
and sales operations.
— Cover the demands made by the competition and ensure growth.
— Help avoid idle operational capacity and excess capacity.
— Choose the right moment to choose the capital increase, issuance of shares,
credits, etc.
— Determine the balance available for short-term investments.

5. Characteristics of capital budgeting

Taking into account López and Torre (2009), they present some characteristics of
the capital budget:

— Provides the possibility of making important changes in the means of

production, by being able to reorient the investment policy in various directions:
growth, reduction, diversification, restructuring, etc.
— Related to the above, it offers the possibility of influencing the company's
current market.
— Provides the possibility of radically changing the company's financial policy.

6. Differences between capital budgeting and other budgets

Capital budgeting covers aspects of the long-term future; the consequences of

investments in real estate, machinery, equipment, product development, and similar
assets that, in general, will affect the well-being of the company for many years.

Budgets project the details of the company's activities in current periods (1 year).

7. Project classes

According to Richard M. Lynch and Robert W. William Son in his management

accounting book considers that most capital projects can be classified in some of
the following ways:

— Replacement: When certain basic machines or equipment wear out, they have
to be replaced with similar ones. Urgency is often the reason for selecting a
replacement project.
— Product or process improvement: Among capital investment plans, those
aimed at producing additional income or cost savings are of particular

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 importance. The acquisition of new special or automated equipment for the
transformation of a predominantly manual operation into a mechanized one may
be considered if the anticipated cost savings are considered adequate.
— Expansion: A developing company usually faces decisions related to the form
and pace of its expansion. Large investments can be made in opening a second
floor; in the expansion of buildings and new equipment, in the acquisition of
another company through a merger; or in the development of a large-scale
advertising campaign.

Furthermore, Almeida Hidalgo (2007) complements the types of investment

projects, such as:

—Replacement of equipment or buildings or Replacement.

As they are; maintenance of the business consisting of the continuation of

product development through current production processes. Also in cost
reduction projects such as labor, raw materials, etc. That give a lower production
cost as a benefit.

It can also be added that it is an analysis that is related to the decision of

whether or not an existing asset should be replaced.

— Projects: New products, expansion of existing products or Expansion.

Caused by competition and the development of markets, as well as the evolution

of products. The projects occur in such a wide range based on the company's
growth expectations and vary from one to another, since it is important not to
lose sight of the characteristics of the companies, which, although they have
points of comparison, do not always The application of the projects will be the
same.

Many executives are confused at this point, since they expect to have a
development that has already been applied as a cooking recipe and they put it
into practice as if the company's resources, its economic environment and the
development of its production technology were similar. Make no mistake, it
requires time to study and master 100% of the knowledge of your company.
Since its survival in the worlds of economics and finance depends on this.

It can also be added that an expansion project is defined as one that requires

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 the company to invest in new facilities to increase sales.

8. Benefits

Bierman, Harold (1996) mentions that investment decisions are very important
since they involve the allocation of large sums of money and for a long term. These
decisions can imply the success or failure of a company. They are also important
because it is difficult to back out of such a decision, in contrast to a bad decision
regarding accounts receivable or inventories. For example, an expansion of facilities
that is not accompanied by greater production and sales implies failure for a
company. Producing a new line of products whose demand does not materialize
can spell the end for a company. Few companies can recover after making poor
investment decisions. Finally, these investments are related to the distant future
which increases the risk when making these investment decisions.

A bad investment decision in a large and important company within a country may
not only adversely affect it, but its failure also affects its suppliers, its clients and its
employees, affecting the general economy of the country.

9. Capital Budgeting Process

An investment project can be expressed in the form of a probability distribution of

possible cash flows. Given a probability distribution of a cash flow, we can express
the risk quantitatively as the standard deviation of the distribution. As a result, the
selection of an investment project can affect the risky nature of the company's
business, which in turn can affect the rate of return required by investors.

However, for introductory purposes of capital budgeting we hold risk constant.

Capital budgeting involves:

— The generation of investment project proposals, consistent with the company's

strategic objectives.
- Project cost.
— The estimate of incremental operating cash flows including depreciation and after
taxes for the investment project.
— The evaluation of the project's incremental cash flows.
— Estimation of the degree of risk of the project's cash flows.
— Appropriate cost of capital at which cash flows should be discounted.
— Value at NPV (net present value), to obtain an estimate of the value of the assets
for the company.

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 — Compare the NPVs with the cost of capital, to decide on their expected return.
— The selection of projects based on an acceptance criterion of value
maximization.
— The continuous reevaluation of implemented investment projects and the
performance of subsequent audits for completed projects.

10. Procedure for the Evaluation of the Capital Budget.

Taking into account Almeida Hidalgo (2007), the procedure is:

— Calculate the initial investment.

The initial investment of a project is the total resources that are committed at a
certain time to achieve greater purchasing power. It is convenient to clarify that
the resources are the cash disbursements required by the project to begin
developing its own activity; that is, to generate the benefits for which it was
conceived.

— Calculate Cash Flows.

The concept used to measure the results of the activity of companies or a

project is that of profit rather than the cash flow it generates. Hence the
question, which of the two concepts is the accepted one for evaluating a
project? Why is a company's cash flow given greater importance to evaluate an
investment project than profit?

The concept of profit depends on the subjectivity of the accountants regarding

the adjustments that are made in the company at the end of each period, for
example. The amount of the bad debt adjustment depends on what the
company's accountant determines using a certain method, which may vary
based on the opinion of another person in the organization. Another discrepancy
among accountants consists of the items that must be included in the results of
the year, either capitalized or deferred, for example. Certain improvements for
the benefit of a fixed asset can be considered as expenses of the period or
capitalized.

To determine the accounting profit, opportunity costs are not taken into
consideration, which are important to evaluate an investment project.

The accounting profit doubles the effect of depreciation, since on the one hand it
is charged to the income deducting it to determine the taxable profit, although

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 this does not imply a cash outlay, and on the other hand, the cash savings
generated by the depreciation due to its tax effect.

— Calculate salvage value

After analyzing cash flows, to measure the value of a company, we find it

necessary to resort to tools that reflect the true value of the companies. This is
how the Market Value Added - MVA -, the Economic Value Added - EVA - and
the VCA – Added Cash Value, they give an account of the true value of
companies, from the market point of view and according to their activities that
add or subtract value to the organization.

The EVA is computed by taking the Spread - Margin - between the rate of return
on capital r and the cost of capital c* and then multiplying the result by the
economic book value of the capital committed to the business. The difference
between the total market value - the amount that investors can take away - and
the invested capital - the money they have put in - is the VA. This means that
the market valuation of a company's share is equal to the capital that the
company has actually invested plus a premium for its projected EVA and
discounted to a present value.

The VCA technique is a refinement or advancement of the EVA in the sense that
the final test of value creation is done on the movements of generation of
available working capital funds.

11. Evaluation methods

There are various ways to evaluate investment projects, here are some of the most
common.

According to Flores Soria (2014):

— Payback period: One way to measure the value of an investment is

relate your monetary benefits (performance, savings) to the investment you
produces them.
• P = Recovery period.
• I = Initial investment
• A = Annual cash inflow (after-tax cash
savings)

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— Accounting method: The accounting method is called this because it
determines performance based on accrual basis accounting, in contrast to the
cash basis. As a rate of return, the resulting percentage is a measure of
productivity, eliminating the main disadvantages of the payback period method.

• R= accounting rate of return.

• A= annual cash inflow (after-tax cash
savings)
R=4D • Original investment.
Yo • D= depreciation

— Discounted cash flow: Determining the

potential return on capital investment projects through discounted cash flow
methods is based on the concept of the time value of money, implemented by
simple mathematical techniques.

1. The amount taken in loans

2. The interest rate (the rate of return from, the point of view
of the lender)
3. The period of time during which borrowed money will be
used.

According to Polimeni (1990), he mentions that the following procedures are used to
prepare capital budgeting:

— Refund technique

The repayment technique measures the period required to recover the initial
net cash outlay.

For example, consider the following group of three mutually exclusive projects,
each with an initial net cash outlay of US$18.000, and the following cash flow
from operations:

YEAR PROJECT A PROJECT B PROJECT C

1 US$ 6,000 US$ 6,000 US$ 15,000

2 5,000 5,000 1,000
3 3,000 3,000 1,000
4 4,000 4,000 500
5 5,500 1,000 500

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 6 2,000 -2,000 14,000

The reimbursement calculation for the three projects is as follows:

CUMULATIVE CASH FLOW FOR THE PROJECT:

AFTER THE YEAR: TO b c
1 US$6,000 US$6,000 US$15,000
2 11,000 11,000 16,000
to 14,000 14,000 17,000
4 18,000 18,000 17,500
5 ____
18,000

For both projects A and B, the initial net cash outlay of US$18.000 will be
recovered in 4 years.

In the case of project C, this will be recovered in 5 years. Therefore, the

payback for projects A and B is 4 years, and for project C, 5 years.

According to the repayment decision rule, a project is attractive when the

repayment period is less than an arbitrarily selected period specified by
management. For example, if management specifies that a project must have
a payback period of 4 years or less, then only projects A and B should be
considered acceptable.

Payback is a popular technique due to its ease of calculation; However, its

deficiencies are so great that its use is not justified. First, it should be obvious
that although projects A and B have the same payback because they have
identical cash flow patterns for the first 4 years, project A is undoubtedly more
attractive. This is because: 1) project B has a lower cash inflow in year 5 than
project A, and 2) project B has a cash outflow in year 6, while project A has a
lower cash inflow. .

The erroneous conclusion that projects A and B are equal according to the
payback technique is because this technique does not take into account all
cash flows. That is, the reimbursement technique violates the first essential
property for a capital budgeting technique. Superficial observation also
suggests that project C is more attractive than projects A and B, although it
has a longer payback period. Note that the pattern of recovery of the initial net
cash outlay of US$18.000 is such that more is received in the early years of
project C compared to the other two projects.

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 Because of the time value of money, this makes project C more interesting.
The payback technique does not consider the timing of cash flows. Therefore,
it also violates the second essential property of a capital budgeting technique.

— Accounting Rate of Return Technique

The accounting rate of return is calculated by dividing the average net profit
after taxes by the initial net cash outlay. Note that this technique uses net
income after taxes instead of cash flow from operations.

To illustrate the calculation of the accounting rate of return, consider project C

and assume that the net income after taxes is as follows:

1 6,000
US$
2 -3,000
3 -3,000
4 - 1,000
Yes -1.000
6
5,000
Total net profit
about the life of the project 3,000
use
s
NET PROFIT AFTER TAX
YEA
R
The average annual net profit after taxes is US$500 (US$3000/6). The
accounting rate of return is then:

Average annual net profit after taxes

Retorting accounting rate = ----------------------------—— ,.:--------------------------------------
Initial net cash disbursement

US5500
US$18,000

2,8%

The standard for deciding whether a project is acceptable or not is that the
accounting rate of return must exceed the required rate of return. For example, if
the required rate of return is 10%, project e would not be acceptable under the
accounting rate of return decision rule. When selecting from a group composed
of mutually exclusive projects, the alternative with the highest accounting rate of
return is the most attractive.

The accounting rate of return technique has two important disadvantages. First,
it measures the economic benefits of a project in terms of net profit after taxes,
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not cash flow. Consequently, it is difficult to give a meaningful economic
interpretation to the resulting return measure. Second, even if one could justify
using net income after taxes instead of cash flow, it does not take into account
the time value of money.

A shortcoming shared by payback and accounting rate of return techniques is

that they do not consider the time value of money, the second property. The net
present value, profitability index and internal rate of return techniques do take
into account the time value of money and are therefore known as discounted
cash flow techniques. Since discounted cash flow techniques require the
calculation of the present value of a project's cash flow, it is necessary for
management to specify an interest rate at which the cash flow will be
discounted. This discount rate or interest rate is called the required rate of
return.

The net present value (NPV) technique is a discounted cash flow technique. It is
a measure of the dollar utility of a project in terms of present value. The NPV of
a project is determined by calculating

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 first the present value of the cash flow from operations using the required rate
of return, and then subtracting the initial net cash outlay. That is to say
NPV = PV of cash flow from operations - Net initial disbursement of
box

To exemplify the NPV calculation, consider project D. The initial net cash
disbursement is US$15,408.

CASH FLOW
YEA THE OPERATIONS
R
US$4,000
4,000
5,000
8,000

Assuming the required rate of return is 10%, the NPV for project O is calculated
as follows:

(1) (2)
CASH FLOW FROM US$1 PV* PV AT 10%
YEAR OPERATIONS AT 10% KD x (2)}

1 US$4,000 0.909 US$3,636

2 4,000 0.025 3.304
3 5,000 0.751 3,755
9,000 0.683 5.464
4

Present value of cash flow from operations USS 16,159

Less: Initial net cash disbursement 15 408

VPN USS 751

— Profitability Index Technique

The profitability index (RI) technique (also known as the benefit-cost ratio and
profitability index) is a variant of the NPV technique. It is calculated by dividing
the present value of cash flow from operations by the initial net cash outlay. That
is to say,

Yo _ Present value of cash flow from

operations Initial disbursement net of cash

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 The IR measures the amount of present value benefit per dollar of the initial net
cash outlay.

For example, it was previously shown that if 10% is the required rate of return,
the present value of the cash flow from operations is US$16,159 for project D.
Since the initial net cash outlay is US$15.40S, the IR for project D is

US$16 1 59
IR for project D assuming a required return rate of 10% = -r"-' US$15,408
- 1.05

The decision rule to determine if a project is attractive is that the IR must be

equal to or greater than 1. Note that this is equivalent to having a NPV equal to
greater than O. The decision rule for selecting from a group of profitable and
mutually exclusive projects using IR as a measure of profitability is to select the
project with the highest IR. Independent projects are ranked in order of priority,
from the highest IR (most advisable) to the lowest (least advisable).

— Internal rate of return technique

The internal rate of return method (also known as rate of return or time-adjusted
return) calculates the expected return on an investment. The internal rate of
return (IRR) for an investment is defined as the discount rate that makes the
present value of the cash flow from operations equal to the initial net cash
outlay.

Project D exemplifies the calculation of the IRR, the discount rate that deduces
the cash flow from operations of US$4.000, US$4.000, US$5.000 and US$5.000
for years 1 to 4 , respectively, so that its present value is equal to the initial net
cash disbursement of US$15.40S.

The discount rate that will make the cash flow from operations equal to the initial
net cash outlay is determined by trial and error. Below is the present value of
cash flow from operations using a 10% discount rate:

CASH FLOW VP OF USS1 AT

YEAR THE OPERATIONS 10% PV AT 10%

1 US$ 4,000 0.909 US$3,636

2 4.000 0.826 3,304
3 5,000 0.751 3,755
4 8,000 0.683 5,464
Total US$16,15
9

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The total present value is US$16,159. Since this is not equal to the initial net
cash outlay of US$15.40, 10% is not the IRR. A different discount rate should be
tried. Should a higher or lower discount rate be used? Remember that the
higher the discount rate, the lower the present value. Since the 10% discount
rate generated a higher present value than the initial net cash outlay, a higher
discount rate must be used so that a lower present value is obtained. Below is
the present value using a rate of 14%:

CASH FLOW FROM US$1 VP

YEAR OPERATIONS AT 14% PV AT 14%

1 US$4,000 0,877 USS 3,508

2 4,000 0.769 3,076
3 5,000 0.675 3,375
4 8,000 0.592 4,73
Total 6 US$14,695

The present value using a 14% discount rate is US$14,695. This value is less
than the initial net cash disbursement of US$15.40S. Therefore, the correct
discount rate should be between 10% and 14%. At 12%, the present value is
exactly equal to the initial outlay, as shown below:

CASH FLOW US $1 PV
YEAR PV AT 12%
THE OPERATIONS AT 12%

1 US$4,000 0 893 US$3,572

2 4,000 0.797 3,188
3 5,000 0.712 3,560
4 8,000 0.636 5,088
Total US$15,408

Since the discount rate that makes the cash flow from operations equal to the
initial net cash outlay is 12%, the discount rate is the IRR for project D.

A trial and error procedure should be used to determine the IRR when the cash
flow from operations is not the same in each year. There is no shorter or faster
procedure to find the exact rate. Some companies have developed, or have
access to, a computer program that calculates IRR. Some pocket calculators
come with a built-in feature that will determine the IRR.

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Often, a discount rate may not be found that gives the exact net initial cash
outlay. Assume that the initial net cash outlay for project D is US$15,315 instead
of US$15.40S. The 12% discount rate would generate a present value of
US$15.40S.

There are two ways to determine a more accurate IRR. First, an approximation
method can be used based on the interpolation values from the present value
table. However, the more accurate method is to use a more detailed present
value table, which provides present values for discount rates between 12% and
13%. For example, a discount rate of 12.2.10 would provide a present value for
the cash flows from operations in the second example of US$15,315.

Once the IRR has been calculated for a project, it can then be determined
whether it is acceptable. Management must decide on the minimum rate of
return that an alternative must earn (or generate) to be acceptable. The
minimum rate of return specified by management is the required rate of return,
commonly known as the hardship rate. For example, if management specifies a
minimum (difficulty) rate of return of 10%, then project O would be acceptable
since its IRR is 12%. On the other hand, if a minimum (difficulty) rate of return of
14% is specified, alternative D would be unacceptable. To summarize, the IRR
decision rule could be stated as: if the IRR is greater than or equal to the
difficulty rate, the project is attractive.

According to the IRR criterion, the most profitable alternative of a group of

mutually exclusive projects is the one with the highest IRR. Independent projects
are classified according to their IRR: the higher the TIR, the higher the priority.

The advantage of the internal rate of return is that it considers the time value of
money.

Furthermore, the management understands her easily. Management often

analyzes projects in terms of performance. However, there are several
disadvantages to this technique. The first is that the internal rate of return is
affected by the volume of the investment, as with the profitability index
technique. For example, consider an investment of US$100 that has an IRR of
100% and an investment of US$100,000 with an IRR of 18% for a firm that has
specified a hardship rate of 10%. Which investment is more interesting? This
aspect will be analyzed later in the chapter.

A second disadvantage is that the internal rate of return calculation assumes

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 that cash flow from operations can be reinvested at the internal rate of return.
So, for example, if an alternative is expected to have an IRR of 25%, it is
assumed that each time cash flow is received from operations, the company has
the opportunity to reinvest the cash flow and earn a return of 25% on the rest of
the project's life.

12. Techniques for evaluating risk in capital budgeting.

According to Almeida Hidalgo (2007). Strategies to diversify risk in projects are very
varied and form a fundamental part of increasing performance at a given level of
risk.

Cash flows related to capital budgeting projects are future cash flows, which is why
understanding risk is of great importance to making appropriate capital budgeting
decisions.

Most capital budgeting studies focus on the problems of calculation, analysis and
interpretation of risk. This article aims to explain the fundamental techniques used to
evaluate risk in capital budgeting, among the most used are subjective system, the
expected value system, statistical systems, simulation and risk-adjusted discount
rates, which are presented in detail below.

Variability

The terms risk and uncertainty are often used alternatively to refer to the variability
of project cash flows.

— Subjective system.

The subjective system for risk adjustment involves calculating the net present
value of a project to then make the capital budgeting decision based on the
decision maker's subjective assessment of the project's risk through the
calculated return.

Projects that have similar net present values but are believed to have different
degrees of risk can be easily selected, whereas projects that exhibit different net
present values are much more difficult to select.

The use of fluctuation techniques such as using optimistic, very likely, and
pessimistic estimates of project returns is also somewhat subjective, but these
techniques allow the decision maker to make a slightly more disciplined guess
regarding comparative risk. of the proyects.

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— System of expected values.

This system involves using estimates of different possible outcomes and the
combined probabilities of these occurring to obtain the expected value of
performance. This type of system is sometimes called "Decision Tree Analysis"
because of the branch-like effect of graphically representing these types of
decisions.

This system does not directly address the variability of project cash flows, but
rather uses what can be considered risk-adjusted cash flows to determine the
net present values used to make the decision.

The expected value system is an improvement over purely subjective systems,

although it also has a certain degree of subjectivity.

— Statistical systems.

Techniques for measuring project risk using standard deviation and coefficient of
variation. In this a study of the correlation between projects is carried out. This
correlation, when combined with other statistical indices, such as standard
deviation and expected value of returns, provides a framework within which the
decision maker can make risk-return alternatives related to different projects in
order to select the best ones. adapt to your needs.

Generally speaking, the further into the future the cash flows to be received are,
the greater the variability of these flows.

Highly sophisticated statistical techniques have been combined into a body of

knowledge called "Portfolio Theory", which offers techniques for selecting the
best among a group of available projects taking into account the risk-return
propensity or utility function. of the company.

These systems are not subjective, since they consider expected values,
standard deviations and correlations between projects to select those that best
meet the administration's objectives.

— Simulation.

Simulation is a sophisticated system with statistical bases to deal with

uncertainty.

Its application to capital budgeting requires the generation of cash flows using
predetermined probability distributions and random numbers. By putting together
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 different cash flow components in a mathematical model and repeating the
process many times, a probability distribution of project returns can be
established.

The procedure of generating random numbers and using probability distributions

for cash receipts and disbursements allows values for each of these variables to
be determined. Substituting these values into the mathematical model results in
a net present value.

By repeating this procedure, a probability distribution of net present values is

created.

The key to successful simulation of the return distribution is to accurately identify

the probability distributions for the variables being added and formulate a
mathematical model that truly reflects the existing relationships.

By simulating the different cash flows related to a project and then calculating
the NPV or IRR based on these simulated cash flows, a probability distribution of
the returns of each project can be established based on the NPV or the IRR
criterion. .

With this type of systems the decision maker can determine not only the
expected value of the given or improved performance. The performance of the
simulations offers an excellent basis for making decisions, since the decision
maker can consider a continuum of risk-return alternatives instead of a simple
point estimate.

— Risk-adjusted discount rates.

Another way to treat risk is to use a risk-adjusted discount rate, k, to discount the
project's cash flows. To properly adjust the discount rate, a function that relates
risk and returns to the discount rate is necessary.

Such a risk-return function or market indifference curve, in this case the risk is
calculated by means of the coefficient of variation. The market indifference curve
indicates that the cash flows related to a risk-free event are discounted at an
interest rate. Consequently, this represents the risk-free rate of return.

When they are discounted at a given risk rate, this must be calculated as close
as possible to business reality, since if a company discounts risky cash flows at
a rate that is too low and accepts a project, the company's price can decline and
therefore more dangerous for investors.

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13. Budget for Capitalizable Disbursements and their Relationship with Cash
Flows.

Capitalizable disbursements are made to acquire new assets for expansion, to

replace or modernize existing fixed assets within the company.

To evaluate capitalizable outlay alternatives, the after-tax cash inflows and outflows
related to each project must be determined. Cash flows are evaluated, rather than
evaluating accounting figures, because they are the ones that directly affect the
company's ability to pay bills or purchase assets. The accounting figures and cash
flows are not necessarily the same because the Income Statement represents
certain expenses that do not represent cash disbursements. When a planned
purchase is intended to replace an existing asset, the incremental cash inflows and
outflows resulting from the investment must be evaluated.

— Conventional cash flows.

The conventional cash flow pattern consists of an initial outlay followed by a

series of cash inflows. This rule is related to many types of capitalizable
expenditures, for example, a company can spend a certain amount "X" of money
today and foresee the result of a number "Y" of inflows at the end of each year
for a certain number of years.

— Unconventional cash flows.

An unconventional cash flow pattern is one in which an initial outlay is not

followed by a series of inflows. An example is the form of alternating entries and
exits or an entry followed by several disbursements. A common type of
unconventional cash flow pattern results from purchasing an asset that
generates cash inflows for a period of years, repairs it, and again generates
cash flow for several years.

14. Planification and control

Capital investments, within which fixed assets are included, are those whose returns
are distributed in the future over a period of time greater than one year.

Hence, capital budgeting is a process of selecting capital investments.

The success or failure of management (public or private sector) can depend largely
on the quality of its decisions regarding capital budgeting; This is because fixed
assets (or capital assets) are productive assets.

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 The selection of capital assets requires the design of very particular strategies and
management guidelines for many years, making it quite difficult to reverse a
decision that over time is shown to be inappropriate.

Therefore, capital budgeting decisions are often critical to the economic benefits of
the organization.

Financial and investment decisions are mutually interdependent and should

therefore not be considered separately. The financial planning process analyzes the
cause and effect relationships between the business's growth objectives, the
investments necessary for this effect, and the methods to finance them.

Financial planning defines the business model on which to foresee different

scenarios and, ultimately, determine and approve the company's capital budget
(long term), as well as the annual budget (short term).

15. Importance

According to Polimeni (1990), capital budgeting decisions play an important role in

determining whether a company will be successful, for three reasons.

First, the cost commitment of a particular project can be enormous. Second, it is not
the amount of money itself that is related to the success of a firm; rather, it is the
strategic role that the decision plays in achieving the firm's long-term objectives.
Some capital budgeting decisions are routine events that do not change the course
or risk of a company.

For example, efficiency may be increased when management decides to replace its
current telephone system with a better one, but it is doubtful that this capital
budgeting decision will be hailed in the boardroom as a distinctive determination. In
contrast to routine capital budgeting decisions, there are strategic capital budgeting
decisions that will impact the firm's future market position in its current product lines
or that will allow it to expand into a new product line. in the future.

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 CONCLUSIONS

— An effective capital budget can improve both the timing of asset acquisitions and the
quality of proven assets. A company that forecasts its capital asset needs in
advance will have the opportunity to purchase and install those assets before they
are needed.

— Capital budgeting is important because asset expansion usually involves very large
expenses and before a company can spend a large amount of money, it must have
sufficient funds available. Therefore, a company contemplating a major capital
expenditure program should establish its financing several years in advance so that
the required funds are available.

— In all companies it is necessary to make conventional as well as unconventional cash

flow expenses since these guarantee that companies renew themselves and
generate more performance in the future, which is why decision making and
planning are a priority. .

— For the execution of the projects established in the capital budget, companies in
many cases do not have the required funds, which is why, together with the banking
system, the Capital market, constitute the two sources of financing.

— The net present value is a tool that allows you to visualize whether a project
established in the capital budget is favorable or unfavorable for the organization. On
the other hand, the cash flow is that in which only the income and costs attributable
to the project are recorded and which would not have been incurred if the project
had not been executed.

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 BIBLIOGRAPHIC REFERENCES

Almeida Hidalgo, I. (2007). Capital Budget. Lima: Cayoa.

Bierman, Harold. (1996). Strategic financial planning. 2nd ed. Mexico: Compañía
Editorial Continental SA

Besley, Scott and Brigham, Eugene. (2008). Fundamentals of financial

administration. Mexico: Cengage Learning.

García Mendoza, Alberto. (1998). Evaluation of investment projects. Mexico: Mc

Graw Hill.

Flores Soria, Jaime. (2014). Costs and budgets . 5th ed. Lima: Maximilian.

Lopez, M. and Torre, J. (2009). Budget Programming: Slides and Practical

Cases. Granada: Copicentro SL

Lynch, Richard and Williamson, Robert. (1990). Accounting for management.

Mexico: CECSA

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