CAPITAL EXPENDITURES

What are Capital Expenditures?

• Capital expenditures refer to funds that are used by
a company for the purchase, improvement, or main
tenance of long-term assets to improve the efficienc
y or capacity of the company.
• Also known as CapEx or capital expenses
• Include the purchase of items such as new eq
uipment, machinery, land, plant, buildings or wareh
ouses, furniture and fixtures, business vehicles
, software and intangible assets such as a patent
or license.
Definition of Capital Expenditure
• “Funds spent in the expectation of securing a
stream of benefits, which may take some time
to start flowing and which may last for some y
ears.” The amount spent is very often sub
stantial.
Types of Capital Expenditures

1. Expenses for the maintenance

of levels of operation present wi
thin the company.
2. Expenses that will enable an i
ncrease in future growth.
Importance of Capital Expenditures

1. Long-term Effects
2. Irreversibility
3. High Initial Costs
4. Depreciation
Challenges with Capital Expenditures

1. Measurement Problems
2. Unpredictability
3. Temporal Spread
 Efficient Capital Expenditure
Budgeting Practices
1. Structure Before You Start
2. Think Long-Term
3. Use Good Budgeting Software
4. Capture Accurate Data
5. Detail Levels Should Be Optimal
6. Form Clear Policies
Capital Expenditures Example
CAPITAL EXPENDITURES
Investment Appraisal
Techniques
 Technique # 1. Payback Period
Method:

• Expressed in years, which it takes the cash i

nflows from a capital investment project to eq
ual the cash outflows.
• The number of years required to recover th
e cost of the investment.
• It is a rough measure of liquidity and rate of p
rofitability.
Example:
Bennett Company is a medium sized metal fabricator
that is currently contemplating two projects:
• Project A requires an initial investment of $42,000,
• Project B an initial investment of $45,000.
Data for Bennett Company
Payback Period Method
The payback method is the amount of time re
quired for a firm to recover its initial investment in
a project, as calculated from cash inflows.
Decision criteria:
• The length of the maximum acceptable payback period
is determined by management.
• If the payback period is less than the maximum accept
able payback period, accept the project.
• If the payback period is greater than the maximum acc
eptable payback period, reject the project.
We can calculate the payback period for Bennett
Company’s projects A and B using the data in Table 10.1
.
• For project A, which is an annuity, the payback peri
od is 3.0 years ($42,000 initial investment ÷ $14,000
annual cash inflow).
• Because project B generates a mixed stream of cash
inflows, the calculation of its payback period is not
as clear-cut.
• In year 1, the firm will recover $28,000 of its $45,000 initi
al investment.
• By the end of year 2, $40,000 ($28,000 from year 1 + $12,0
00 from year 2) will have been recovered.
• At the end of year 3, $50,000 will have been recovered.
• Only 50% of the year-3 cash inflow of $10,000 is needed t
o complete the payback of the initial $45,000.
• The payback period for project B is therefore 2.5 ye
Merits of Payback Period Method
• (a) It is simple to apply, easy to understand and of p
articular importance to business which lack the appr
opriate skills necessary for more sophisticated tech
niques.
• (b) In case of capital rationing, a company is co
mpelled to invest in projects having shortest payb
ack period.
• (c) This method is most suitable when the future is v
ery uncertain. The shorter the payback period, the l
ess risky is the project. Therefore, it can be consid
ered as an indicator of risk.
Merits of Payback Period Method
(d) This method gives an indication to the pros
pective investors specifying when their funds are lik
ely to be repaid.
(e) Ranking projects according to their ability to rep
ay quickly may be useful to firms when experie
ncing liquidity constraints. They will need to exercis
e careful control over cash requirements.
(f) It does not involve assumptions about future inte
rest rates.
Demerits of Payback Period Method
(a) It does not indicate whether an investment should be ac
cepted or rejected, unless the payback period is compared w
ith an arbitrary managerial target.
(b) The method ignores cash generation beyond the payback
period and this can be seen more a measure of liquidity than
of profitability.
(c) It fails to take into account the timing of returns and the c
ost of capital. It fails to consider the whole life time of a proje
ct. It is based on a negative approach and gives reduced imp
ortance to the going concern concept and stresses on the ret
urn of capital invested rather than on the profits occurring fro
m the venture.
Demerits of Payback Period Method
(d) The traditional payback approach does not consider the s
alvage value of an investment. It fails to determine the payba
ck period required in order to recover the initial outlay if thing
s go wrong. The bailout payback method concentrates on thi
s abandonment alternative.
(e) This method makes no attempt to measure a percentage
return on the capital invested and is often used in conjunctio
n with other methods.
(f) The projects with long payback periods are characteristica
lly those involved in long-term planning, and which determine
an enterprise’s future. However, they may not yield their high
est returns for a number of years and the result is that the pa
yback method is biased against the very investments that ar
e most important to long-term.
Thank You

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