| CHAPTER 11 CAPITAL EXPENDITURES Capital expenditures are planning and controlling the strategic (long-term) plan. A capital expenditure is the use of funds to obtain operational assets that will: 1. Help earn future revenues 2. Reduce future costs 3. Increase capacity (Demand The usual capital expenditure is: 1. Plant 2. Equipment 3. Property 4. Patents 5. Major renovations Typically, capital expenditures require a large amount of cash (and debt). The capital expense budget: 1. Major capital additions - Cash Cash Cash -Unique project- There are individual budgets created for each capital program -Sometimes capital projects can be the result of new mission statements- (Re- engineering) -Non - recurring projects -Technology-Companies must stay on the ‘cutting’ edge 2. Minor capital expenditure - Smaller amounts of cash -Special tools Minor capital expenditures should not be maintenance items. R and M are in the OH budget Project orientation in capital expenditures -Typically, each capital project is budgeted as a separate project -It is easier to control (and get approved) -Information is paramount -It must be accurate, reliable The project must have financial and non financial information. Financial and Non-Financial Market Trends /Govt. Regs. Financial Trends /Technoloy Cash flows / Operating volumes
The capital project must completely analyses the concept of cash in and cash out. Time dimensions What is the life of the Project? Is the LT CP consisitent with the ST TP and ST OP.
Benefits of the Capital Plan: Enables the management to plan for resources to: 1. Satisfy customers 2. Meet future demands 3. Meet competitive demands 4. Ensure growth 5. Avoid idle capacity 6. Avoid excess capacity 7. Avoid poor investing (less ROI then if the money was in the bank)
Responsibility for CP Top management is involved in the approval side of capital planning. However, the dept. managers must highly involved in the planning process. -Proposal submitted (w/ reasons for capital need) -Information -Start and finish dates -Top management must set the policies and procedures
The CP udget Process Capital expenditures can effect the LT. financial health of the company since many decisions cannot be reversed. Management should not undertake a capital project unless: 1. It is necessary for continued 0perations 2. It is probable that it will yield long term ROI
The decision to undertake a capital project must be based on: 1. Investment worth- Selecting the best alternative based on their economic worth to the company 2. Financial decisions- Do we have the money? There are other factors that need to be considered: 1. Urgency- Is the machine broken? 2. Repairs-Are parts available? 3. Credit- Are the terms too good to pass up? 4. Non-economic- Government regs., supplier offers, etc.
SWOT analisises are required. Measuring the economic value There are, generally speaking, 4 methods of the economic worth of a project:
The 4 methods are divided into two methods: A. Discounted Cash Flow Capital projects are assets. Therefore, the capital project should be measured like any other investment. The investment should be considered like a rate of return (Interest rate). The cash outflows for the investment should be related to the cash inflows of the investment.
The investment should consider the time value of money. The cash outflow (today) has a present value of money. The cash inflows (tomorrow) represent the return that will happen in the future. The future inflow must be discounted to the present. Discounting the future money received to today’s money involve the concept of present value. 1. Present value of a single amount PV= F(1/ 1+i) PV= Present Value F= Future sum of money i= Interest rate per period n= Number of periods (page 404)
Present value of More then one future amount (Annuity)
There are projects that involve a series of future cash inflows. page 406 How can the PV system be used to rank projects There are 3 factors that must be considered: - Initial cash outflow - Future cash inflows - Target rate of return Review the example on page 410
2. Internal rate of return The present value of money method measures projects against a predetermined (by management) Rate Of Return The internal rate of return computes the true rate of return.
The internal rate has two cases: 1. Net cash inflows are equal for each period. Page 412 (exhibit 11-6) 2. Net cash flows are unequal for two or more periods.
Short Cut Methods 1. The pay back period - The number of years that it will take to recoup the cash investment from the annual cash inflow. Payback in years == Net cash investment / Annual net cash inflow Review the example on page 416 -Quick and easy -Easily screen projects -It does not consider the time value of money
-It does not measure the profitability of the project -It does not consider useful life. 2. The average return on total investment Average cash return = Average annual net inflow on total cash investment vs Cash out flow Review the example page 417
Managerial Judgment -Management must consider the certainty of the information -Morale of the employees and a particular project
Controlling Capital Projects Status reports ‘To date’ reports On schedule/off schedule Post completion audit Cost reports An audit should be completed years after the completion. CHAPTER 11 CAPITAL EXPENDITURES KEY POINTS 1. WHAT IS CAP. LANNING? 2. TIME DIMENSIONS OF CAPITAL PLANNING 3. BENEFITS OF CAPITAL PLANNING 4. WHO IS RESPONSIBLE FOR CAPITAL PLANNING 5. THE CAPITAL PLANNING PROCESS 6. 4 METHODS TO ANALYZE CAPITAL PLANNING 7. MANAGERIAL JUDGMENT |