1. King Faisal University [ ] 1 Business School Management Department Finance Pre-MBA 2010-2011 Dr Abdeldjelil Ferhat BOUDAH 1

2. King Faisal University [ ] CHAPTER 9 THE CAPITAL BUDGETING DECISION PROCESS 2 Dr Abdeldjelil Ferhat BOUDAH

3. King Faisal University [ ] CHAPTER 9 : THE CAPITAL BUDGETING DECISION PROCESS CHAPTER 9 : THE CAPITAL BUDGETING DECISION PROCESS Introduction I- CAPITAL EXPENDITURE MOTIVES II- STEPS IN THE PROCESS III- BASIC TERMINOLOGY Conclusion 3 Dr Abdeldjelil Ferhat BOUDAH

4. King Faisal University [ ] CHAPTER 9 : THE CAPITAL BUDGETING DECISION PROCESS CHAPTER 9 : THE CAPITAL BUDGETING DECISION PROCESS Introduction Long-term investments represent sizable outlays of funds that commit a firm to some course of action. For this reason, the firm relies on specific procedures to analyze and select those investment properly. 4 Dr Abdeldjelil Ferhat BOUDAH

5. King Faisal University [ ] CHAPTER 9 : THE CAPITAL BUDGETING DECISION PROCESS CHAPTER 9 : THE CAPITAL BUDGETING DECISION PROCESS Attention must be given to measuring relevant cash flows and applying appropriate decision techniques. Capital budgeting is the process of evaluating and selecting long-term investments consistent with the firm’s goal of owner wealth maximization. 5 Dr Abdeldjelil Ferhat BOUDAH

6. King Faisal University [ ] CHAPTER 9 : THE CAPITAL BUDGETING DECISION PROCESS CHAPTER 9 : THE CAPITAL BUDGETING DECISION PROCESS Investment for the manufacturing firm is fixed asset, which includes property (land), plant, and equipment. Capital budgeting (investment), and financing decision are treated separately. Once proposed investment has been determined to be acceptable, the financial manager then chooses the best financing method. 6 Dr Abdeldjelil Ferhat BOUDAH

7. King Faisal University [ ] CHAPTER 9 : THE CAPITAL BUDGETING DECISION PROCESS CHAPTER 9 : THE CAPITAL BUDGETING DECISION PROCESS This chapter discusses capital expenditure motives, steps in the capital budgeting process, and basic capital budgeting terminology. 7 Dr Abdeldjelil Ferhat BOUDAH

8. King Faisal University [ ] CHAPTER 9 : THE CAPITAL BUDGETING DECISION PROCESS CHAPTER 9 : THE CAPITAL BUDGETING DECISION PROCESS I- CAPITAL EXPENDITURE MOTIVES A capital expenditure is an outlay of funds by the firm that is expected to produce benefits over a period of time greater than one year. I- CAPITAL EXPENDITURE MOTIVES A capital expenditure is an outlay of funds by the firm that is expected to produce benefits over a period of time greater than one year. 8 Dr Abdeldjelil Ferhat BOUDAH

9. King Faisal University [ ] CHAPTER 9 : THE CAPITAL BUDGETING DECISION PROCESS CHAPTER 9 : THE CAPITAL BUDGETING DECISION PROCESS Current expenditure is an outlay of funds resulting in benefits received within one year. 9 Dr Abdeldjelil Ferhat BOUDAH

10. King Faisal University [ ] CHAPTER 9 : THE CAPITAL BUDGETING DECISION PROCESS CHAPTER 9 : THE CAPITAL BUDGETING DECISION PROCESS Fixed asset outlays are capital expenditures, but not all capital expenditures are classified as fixed assets. A $60,000 outlay for a new machine with a usable life of 15 years is a capital expenditure that would appear on the firm’s balance sheet. 10 Dr Abdeldjelil Ferhat BOUDAH

11. King Faisal University [ ] CHAPTER 9 : THE CAPITAL BUDGETING DECISION PROCESS CHAPTER 9 : THE CAPITAL BUDGETING DECISION PROCESS A $60,000 outlay for advertising that produces benefits over a long time period is also a capital expenditure. However, an outlay for advertising would rarely be shown as a fixed asset. 11 Dr Abdeldjelil Ferhat BOUDAH

12. King Faisal University [ ] CHAPTER 9 : THE CAPITAL BUDGETING DECISION PROCESS CHAPTER 9 : THE CAPITAL BUDGETING DECISION PROCESS Capital expenditures are made for many reasons. The basic motives for capital expenditures are : to expand, replace, or renew fixed assets, or to obtain other less tangible benefit over a long period. 12 Dr Abdeldjelil Ferhat BOUDAH

13. King Faisal University [ ] CHAPTER 9 : THE CAPITAL BUDGETING DECISION PROCESS CHAPTER 9 : THE CAPITAL BUDGETING DECISION PROCESS 13 Dr Abdeldjelil Ferhat BOUDAH Motives for making Capital Expenditure DescriptionMotives A growing firm often finds it necessary to acquire new fixed asset rapidly. Expansion Each time a machine requires a major repairs, the outlay for the repair should be evaluated in terms of the outlay to replace the machine and the benefits of replacement Replacement

14. King Faisal University [ ] CHAPTER 9 : THE CAPITAL BUDGETING DECISION PROCESS CHAPTER 9 : THE CAPITAL BUDGETING DECISION PROCESS 14 Dr Abdeldjelil Ferhat BOUDAH Motives for making Capital Expenditure DescriptionMotives It is often considered as an alternative to replacement, which may involve rebuilding, retrofitting an existing machine or facility. Renewal Some capital expenditure involve a long-term commitment of funds by the in expectation of a future return. Others are difficult to evaluate because they provide intangible returns rather than measurable cash flows. Other purposes

15. King Faisal University [ ] CHAPTER 9 : THE CAPITAL BUDGETING DECISION PROCESS CHAPTER 9 : THE CAPITAL BUDGETING DECISION PROCESS II- STEPS IN THE PROCESS The capital budgeting process can be viewed as consisting of five distinct but interrelated steps that are used to evaluate and select long-term investment. II- STEPS IN THE PROCESS The capital budgeting process can be viewed as consisting of five distinct but interrelated steps that are used to evaluate and select long-term investment. 15 Dr Abdeldjelil Ferhat BOUDAH

16. King Faisal University [ ] CHAPTER 9 : THE CAPITAL BUDGETING DECISION PROCESS CHAPTER 9 : THE CAPITAL BUDGETING DECISION PROCESS 16 Dr Abdeldjelil Ferhat BOUDAH Steps in the Capital Budgeting Process Description Steps listed in order Proposals for capital structure are made at all levels within business organization. And they are carefully scrutinized in terms of costs. Proposal They are formally reviewed in order to assess the appropriateness in light of the firm’s overall objectives and plans, and evaluate their economic validity and risk. Review & Analysis

17. King Faisal University [ ] CHAPTER 9 : THE CAPITAL BUDGETING DECISION PROCESS CHAPTER 9 : THE CAPITAL BUDGETING DECISION PROCESS 17 Dr Abdeldjelil Ferhat BOUDAH Steps in the Capital Budgeting Process Generally, the board of directors reserves the right to make final decisions on capital expenditures, requiring outlays beyond a certain amount Decision Making Once a proposal has been approved and funding has been made available, the implementation phase begins. For minor outlays, implementation is a routine task, whereas it is not for major expenditures that greater control is required to ensure what has been proposed and approved at the budget costs. Implement ation

18. King Faisal University [ ] CHAPTER 9 : THE CAPITAL BUDGETING DECISION PROCESS CHAPTER 9 : THE CAPITAL BUDGETING DECISION PROCESS 18 Dr Abdeldjelil Ferhat BOUDAH Steps in the Capital Budgeting Process Description Steps listed in order Involves monitoring the results during the operating phase of a project. The comparison of actual costs and benefits with those expected and those of previous projects are vital. When actual outcomes deviate from projected outcomes, action may be required to cut the costs, improve benefits, or possibly terminate the project. Follow up

19. King Faisal University [ ] CHAPTER 9 : THE CAPITAL BUDGETING DECISION PROCESS CHAPTER 9 : THE CAPITAL BUDGETING DECISION PROCESS III- BASIC TERMINOLOGY -Independent Versus Mutually Exclusive Projects -Unlimited Funds Versus Capital Rationing. -Accept-Reject Versus Ranking Approaches. -Conventional Versus Nonconventional Cash Flows. -Annuity Versus Mixed Stream Cash Flows. III- BASIC TERMINOLOGY -Independent Versus Mutually Exclusive Projects -Unlimited Funds Versus Capital Rationing. -Accept-Reject Versus Ranking Approaches. -Conventional Versus Nonconventional Cash Flows. -Annuity Versus Mixed Stream Cash Flows. 19 Dr Abdeldjelil Ferhat BOUDAH

20. King Faisal University [ ] CHAPTER 9 : THE CAPITAL BUDGETING DECISION PROCESS CHAPTER 9 : THE CAPITAL BUDGETING DECISION PROCESS III- BASIC TERMINOLOGY - Independent Projects Projects whose cash flows are unrelated or independent of one another; the acceptance of one does not eliminate the others from further consideration. 20 Dr Abdeldjelil Ferhat BOUDAH

21. King Faisal University [ ] CHAPTER 9 : THE CAPITAL BUDGETING DECISION PROCESS CHAPTER 9 : THE CAPITAL BUDGETING DECISION PROCESS - Mutually Exclusive Projects Projects that compete with one another, so that the acceptance of one eliminates the others from further consideration. For example, a firm in need of increased production capacity could obtain it by (1) expanding its plant, (2) acquiring another company, (3) contracting with another company. 21 Dr Abdeldjelil Ferhat BOUDAH

22. King Faisal University [ ] CHAPTER 9 : THE CAPITAL BUDGETING DECISION PROCESS CHAPTER 9 : THE CAPITAL BUDGETING DECISION PROCESS III- BASIC TERMINOLOGY -Unlimited Funds Versus Capital Rationing. The unlimited funds means the financial situation in which a firm is able to accept all independent projects that provide an acceptable return. 22 Dr Abdeldjelil Ferhat BOUDAH

23. King Faisal University [ ] CHAPTER 9 : THE CAPITAL BUDGETING DECISION PROCESS CHAPTER 9 : THE CAPITAL BUDGETING DECISION PROCESS -Capital Rationing. Capital rationing is the financial situation in which a firm has only a fixed number of dollars to allocate among competing capital expenditures. Therefore, the firm must ration its funds by allocating them to projects that will maximize share value. 23 Dr Abdeldjelil Ferhat BOUDAH

24. King Faisal University [ ] CHAPTER 9 : THE CAPITAL BUDGETING DECISION PROCESS CHAPTER 9 : THE CAPITAL BUDGETING DECISION PROCESS III- BASIC TERMINOLOGY -Accept-Reject Versus Ranking Approaches. Accept-reject approach involves evaluating capital expenditure proposals to determine whether they meet the firm’s minimum acceptance criterion. This approach can be used when the firm has unlimited funds, as preliminary step when evaluating mutually exclusive projects, or in a situation in which capital must be rationed. 24 Dr Abdeldjelil Ferhat BOUDAH

25. King Faisal University [ ] CHAPTER 9 : THE CAPITAL BUDGETING DECISION PROCESS CHAPTER 9 : THE CAPITAL BUDGETING DECISION PROCESS III- BASIC TERMINOLOGY -Accept-Reject Versus Ranking Approaches. Ranking approach involves ranking projects on the basis of some predetermined measure such as the rate of return. The project with the highest return is ranked first until to that with the lowest return. Ranking is useful in selecting the best of a group mutually exclusive project, and in situations where capital is rationed. 25 Dr Abdeldjelil Ferhat BOUDAH

26. King Faisal University [ ] CHAPTER 9 : THE CAPITAL BUDGETING DECISION PROCESS CHAPTER 9 : THE CAPITAL BUDGETING DECISION PROCESS III- BASIC TERMINOLOGY -Conventional Versus Nonconventional Cash Flows. Cash flow patterns associated with capital investment can be classified as conventional or nonconventional. A conventional approach consists of an initial outflows followed by a series of inflows. SEE FIGURE 8.1 26 Dr Abdeldjelil Ferhat BOUDAH

27. King Faisal University [ ] CHAPTER 9 : THE CAPITAL BUDGETING DECISION PROCESS CHAPTER 9 : THE CAPITAL BUDGETING DECISION PROCESS -Conventional Versus Nonconventional Cash Flows. A nonconventional Cash flow patterns is any in which an initial outflow is not followed by only a series of inflows. SEE FIGURE 8.2 27 Dr Abdeldjelil Ferhat BOUDAH

28. King Faisal University [ ] CHAPTER 9 : THE CAPITAL BUDGETING DECISION PROCESS CHAPTER 9 : THE CAPITAL BUDGETING DECISION PROCESS III- BASIC TERMINOLOGY -Annuity Versus Mixed Stream Cash Flows. As pointed out in chapter 5, an annuity is a stream of equal annual cash flows, whereas unequal pattern of inflows represents a mixed stream. SEE FIGURES 8.1, 8.2 28 Dr Abdeldjelil Ferhat BOUDAH

29. King Faisal University [ ] CHAPTER 9 : THE CAPITAL BUDGETING DECISION PROCESS CHAPTER 9 : THE CAPITAL BUDGETING DECISION PROCESS Conclusion As it has been said that capital budgeting is based on following the process of decision making, and on the financial situation of the firm. Further, big investments need an important treatment of the capital budgeting process and being so careful to choose the best ways of financing in terms of costs and benefits. 29 Dr Abdeldjelil Ferhat BOUDAH

30. King Faisal University [ ] 30 بحمد الله