1. Capital Budgeting

2. Capital Expenditures
Refer to substantial outlay of funds the purpose of which is to lower costs and increase net income for several years in the future. It includes expenditures that tie up capital inflexibility for long periods. It covers not only outlays for fixed assets but also expenditures for major research on new products and methods and for advertising that has cumulative effects

3. Classes of Capital Expenditures
Replacement investments
Expansion investments
Product line or new market investments
Investments in safety and/or environmental projects
Strategic investments
Other investments

4. Capital Budgeting Planning and control of capital expenditures
Provides a systematic evaluation of the firm’s alternatives
The process in which a business determines whether projects such as building a new plant or investing in a long-term venture are worth pursuing. Oftentimes, a prospective project's lifetime cash inflows and outflows are assessed in order to determine whether the returns generated meet a sufficient target benchmark. (investopedia)

5. Capital Budgeting
Ideally, businesses should pursue all projects and opportunities that enhance shareholder value. However, because the amount of capital available at any given time for new projects is limited, management needs to use capital budgeting techniques to determine which projects will yield the most return over an applicable period of time.

6. Valuation refers to the process of determining the real worth of a proposal to the firm.
Investment is made when a firm spends some of its funds for the establishment of a project. By doing so, the opportunity to use the same funds in other possible project is lost.
Initial investment – amount that has been devoted to a project until it generates cash inflows from operations
Later investment – expenditures made after the first cash inflow.

7. Objectives of Capital Budgeting
Establishing priorities
Cash planning
Construction planning
Eliminating duplication
Revising plans

8. Capital Budgeting System
Preparation and submission of budget requests
Approval of budget
Request for appropriation
Submission of progress reports
Post approval reviews

9. The Capital Budgeting System:
Budget Requests
Budget Requests are those made to include in the corporate budget capital projects which are felt to be desirable by those in the lower organizational levels.
The budget request contains the following:
Project Title;
Cost, including estimates on;
Fixed capital
Working capital
Non-operating outlays
Others, including opportunity cost;

10. The Capital Budgeting System:
Budget Requests
Priority rating of the project;
Profitability of the project;
Timing or the ability to adhere to a construction schedule;
Financing method;
Project classification; and
Project narrative

11. The Capital Budgeting System:
Approval of the Budget
Steps for the Approval of the Budget
Budget requests are forwarded to top management;
Top management decides which projects to recommend to the board of directors;
Top management sends recommendations to the board of directors;
The board of directors approves or disapproves the recommendations; and
Top management informs projects sponsors of the action taken on their projects.

12. The Capital Budgeting System:
Request for Appropriation
The appropriations request usually contains the following:
The request and authority section – this serves to identify the originator and the project;
The narrative section – this details the requesting entity’s justification for undertaking the proposal.
Proposal;
Objectives;
Conceptual framework;
Alternatives; and
Sensitivity and risk
Supporting documentation section – this contains cost estimates and the results of market studies and financial analysis.

13. The Capital Budgeting System:
Submission of Progress Reports
Progress Reports are submitted at regular intervals for the following purposes:
to review the accuracy of the expenditure forecasts;
to provide updated expenditures forecasts; and
to verify the assumptions and economics underlying the acceptance of individual projects.

14. The Capital Budgeting System:
Post Approval Reviews
Post approval reviews are required to satisfy the following objectives:
to provide management with a standard method of evaluating the abilities and judgement of project sponsors;
to identify errors or patterns of error in judgement which can be avoided in future similar situations; and
to help ensure that the quality and accuracy of information attains the highest feasible standards.

15. Evaluation of Proposed Capital Expenditures
Urgency
Repairs
Credit
Non-Economic Factors
Investment worth
Risk involved

16. Methods of Economic Valuation
Payback Method
Average Rate of Return Method
Discounted Cash Flow Method

17. Sample Acquisition Cost 10,000,000 Economic Life 10 years
Salvage Value
100,000
Earnings and Costs per year
Income
5,000,000
Expenses
(2,000,000)
NIBTD
3,000,000
Less: Depreciation (Straight Line)
(1,000,000)
NIBT
2,000,000
Less: Income Tax
(620,000)
Average Net Annual Earnings
1,380,000
*Cash Inflows per year = Net Earnings + Depreciation = 2,380,000

26. MEANING OF RISK, UNCERTAINTY AND SENSITIVITY
Risk is defined as the uncertainty concerning loss. Uncertainty, as a term is synonymous to risk, and as such, they will be used interchangeably in the discussions that will follow. Uncertainty and risk both refer to variations of actual values from average or expected values. The variations referred to in risks is caused by chance, while the variations referred to in uncertainty is caused by errors in estimating.
Sensitivity refers to the effect on investment of changes in some factors, which were not previously determined with certainty.

27. FACTORS AFFECTING RISK
There are four primary factors involved in the evaluation of risks pertaining to capital expenditures. These are the following: (1) possible inaccuracy of the figures used in the evaluation; (2) type of business involved; (3) type of physical plant and equipment involved; and (4) the length of time that must pass before all the conditions of the evaluation become fulfilled.
Estimates could be wrong or inaccurate at times. Accuracy, however, depends on how the figures were obtained. Estimates can be made either by scientific methods or by plain guesswork.
Every type of business has its own degree of risk that is peculiar to itself. The demand for foo, for instance, is more stable than the demand for specialized consumer items like hair dyes. More risk is involved in the operations of a new venture than a business with a successful record of past performance.

28. Physical plants and equipment are also subject to risks
Physical plants and equipment are also subject to risks. Some may become obsolete before their economic life expires. The demand for special equipment like that for DVD players, may diminish without warning. Estimates involving longer periods are usually more prone to inaccuracies than those involving shorter periods. This is true because, most often, changes in the environment happen sooner than expected.

29. SENSITIVITY ANALYSIS
Sensitivity analysis is applicable to capital expenditures involving the purchase or construction of a plant. It is useful for management to know the expected returns that will be generated by the various capacity utilization in the operation of the plant.