CAPITAL BUDGETING

Before engaging in any kind of business activity, a businessman would want to know
beforehand where his resources would go, the expected benefits he may derive there from and
the number of years these benefits would be realized. When already engaged in business, he
may have to make decisions involving additional requirements for long term functions such as
whether to acquire additional units of plant, property and equipment, to replace a machine, and
to buy or lease fixed assets. All these problems require the use of capital budgeting tools and
techniques.

Capital Budgeting

Capital budgeting is the process of planning and controlling long term investments. It involves
evaluation of capital investment proposals, allocation of capital investment funds among
approved projects and programs, and control of such expenditures.

The Administrative Process in Capital Budgeting

The Administrative Process in Capital Budgeting refers to framework of planning and

control a measure which identifies and interrelates the essential requirements for an effective
capital expenditure program.

It consists of the following steps:

 Proposal generation- management encourages all levels within an organization to

make suggestions for capital expenditures. Minor proposals are often reviewed at the
next organizational level while major ones go to higher levels.
 Gathering of Relevant Data on Proposals Submitted - this is undertaken for
proposals where additional data are needed before they can be objectively evaluated.
 Evaluation- capital expenditure proposals, especially the major ones are reviewed to
determine whether they are appropriate or not (considering company objectives and
plans) and the economic benefits that may be derived there from. Cost benefit analysis
is applied by comparing the different cash flows involved.
 Approval and Implementation - approval for capital expenditures is done at different
levels depending on the materiality thereof. In some organizations, managers are given
full authority to decide on expenditures required for continuous operations. After being
approved and funding has been made available, capital expenditures are made and
projects so approved are made operational.
 Controls of Expenditures and Follow-up - actual costs are reported and compared
with budgeted figures so that in case these are deviations, prompt corrected measures
can be adopted. Remedial measures may be cost cutting improvements of benefits and
even termination of project.
What Problems Require Capital Budgeting

Capital budgeting techniques should be used in all decision making problems requiring long
term use of funds. Examples are the following:

 Should an investment be made in a proposed business venture?

 Would it be more advantageous for a business concern to expand or just maintain its
current production/sales capacity?
 Should existing facilities be maintained, replaced, or renewed?
 Which would be more advantageous: continued ownership or sale and leaseback?
 Should facilities be leased out or used in operation?

It may be underscored at this point that capital budgeting problems invariably involve
capital expenditures or outlay of resources that will benefit the business beyond the current
accounting period.

Independent and Mutually Exclusive Projects

In evaluating project proposals, it is advisable to determine whether they are independent

or mutually exclusive

Independent Projects are the projects that do not complete with one another so that the
acceptance of one does not eliminate the others for further consideration. Example: project
proposal A is for increasing production capacity for product A while project proposal B is for
increasing sales volume for Product B in the Visayas and Mindanao regions. In as much as
they are geared towards different objectives, the approval of project A does not eliminate
project proposal B.

Mutually Exclusive Projects are those that complete with one another so that the
approval or acceptance of one eliminates the others in the group for further consideration.
Example: Both project proposals X and Y have been presented to increase production
capacity for the sole product of the company in the same department. In as much as only
one of them has to be adopted, the approval or acceptance of one automatically eliminates
the other.
Cash flows in Capital budgeting

As the word budgeting connotes, cash flows in different alternatives are determined and
their values are computed using a common point in time. The cash flows are investment,
cash returns and terminal values.

Investment - This refers to the net outlay of resources at the inception of a business
venture or special project (or at 0 year): This includes the purchase cost of assets,
incidental cost of assets, incidental costs such as freight in and installation costs, working
capital requirement, and market value of assets already owned and to be transferred to the
venture or project.

For replacement of fixed assets, investment (or net investment) is the net outlay of
resources incidental to replacement itself. Thus, aside from the given items above, there
may be inflows of resources (including savings) at the same time replacement is to be
effected such as net proceeds from sale of the old item of asset and savings in the form of
repairs cost that have to be incurred if the old asset is not replaced (or passed on the buyer
upon its sale). These inflows (and savings) are deducted from the outlays of resources to
arrive at investment (or net investment) in replacement decision problem.

Interest expense is not included in the computation for investment for the inclusion of the
same would distort information in as much as whatever rate return is arrived at in
evaluating project proposals has to be compared yet with the cut off rate which may be the
prevailing cost of capital.

Cash returns - this refers to the cash inflows expected to be realized when the business or
special project is already operational. This is not synonymous to net income for the latter is
net of charges not requiring cash outlays (such as depreciation and amortization of
intangibles and similar charges arising from cost allocation for items included in the
investment figure) and those not related to normal operations. Thus, the amount of cash
inflow is arrived at by adding back these items to net income.

Example: The following data are given on proposed investment of ₱200,000.

Annual revenue for 5 years --------------------- ₱ 80,000

Annual out of pocket operating costs --------- 31,000

And expenses

Depreciable assets included in investment

with physical life of 8 years -------------------- 120,000

Income tax rate ------------------------ ------------------- 35%

The amount of annual cash returns is computed as follows:

Cash returns:

Net income:

Annual revenue ₱ 80,000

Less –

Annual out of pocket operating ₱ 31,000

Cost and expenses

Depreciation expenses (₱120,000/5years) ₱ 24,000

Income before income tax ₱ 55,000

Income tax ₱ 25,000

₱ 8,750

Net income ₱16,250

Add back depreciation (₱120,000/5years) ₱ 24,000

Annual cash returns ₱ 40,250

For decision-making problems involving replacement of fixed assets, cash returns would
refer to incremental cash inflows arrived at but comparing expected cash returns from
using the old assets and those from using the replacement.

Terminal cash flow - this term refers to cash inflow that may be realized upon termination
of a business venture or project and consists of working capital that is expected to be
released therefrom and the realizable value of assets used.

Economic life

This refers to the lengths of period during which economic benefits can be expected from a
venture or project. In the preceding example, the economic life of investment is 5 years
while the physical life of depreciable assets is 8 years. The cost of depreciable assets is
allocated over the 5-year period.