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How to Create and Evaluate a Capital Expenditure Budget

written by: madel57•edited by: Linda Richter•updated: 11/7/2010

"Capital expenditure budget? Do you want to say that my request will not be approved because it is not included in that budget, Miss Kelly? What is in that capital expenditure budget?" demands Engineer Lapuz of his accountant. Let's learn more about capital expenditure budgets.

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    What is in Heller Construction Firm's Capital Expenditure Budget?

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    Heller Construction's accountant, Miss Kelly, explains to Engineer Lapuz the reason for the foreseen disapproval of his request for a computer to be placed in his office. He is the Project Engineer of Heller's current project - a government infrastructure. "Mr. Lapuz, you can use one of our computers here if you wanted to but we cannot submit this request to the president because this is not included in the capital expenditure budget for this year," explains Miss Kelly.

    "Miss Kelly, I cannot do that. I will have a difficult time traveling from this office to the plant site every morning. I will just give one suggestion: Include my request in the next annual budget meeting and tell the Board of Directors' chairman that I am going to use my personal laptop in my office. My contract with the company will last for four years, anyway," replies the engineer.

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    What is a Capital Expenditure Budget and How are Investment Projects Ranked?

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    Capital budgeting refers to planning the utilization of the firm's capital resources for the purpose of maximizing the company's long-term profitability. Making decisions involving capital investment projects is perhaps one of the most difficult jobs of managers. This is because of the peculiar characteristics of capital investment projects. Capital expenditure projects require the long-term commitment of funds and cover a long period of time. Consequently, the elements of uncertainty and risk are almost always present in capital investment decisions. Here we will learn how to create a capital expenditure budget.

    When a firm is faced with the problem of choosing the best project from a number of alternative proposals, each of the proposals must be evaluated using the techniques according to their desirability and acceptability as dictated by the evaluation method used. If problems in ranking arise because of the conflicting results shown by the evaluation methods, the result shown by the discounted cash flow (DCF) methods must be given more weight. However, if ranking problems still exist despite the use of the DCF methods, the result shown by the net present value method, or better still, by the profitability index, should be preferred to the result shown by the discounted cash flow rate of return. The latter is not included in this article because of its very long process in computing.

    Another source of difficulty in the evaluation of capital investment projects arises from the differences in the economic life of the projects being evaluated. For example, assume that Heller Company has two projects - Project X and Project Y. Project X is expected to last for 16 years while Project Y is expected to last for 8 years.

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    What are the Other Factors that Influence Capital Investment Decisions?

    You are considering how to create a capital expenditure budget: Aside from considering the quantitative factors of certain projects just like the one discussed above, the qualitative factors must likewise be considered:

    Economic Conditions

    Economic conditions have a significant influence on capital investment decisions. Changes in economic conditions affect business operations, and, consequently, the decisions involving capital investment projects. For instance, a decline in economic activity may mean a decrease in the demand for the product, sales, and earnings. In this case, expansion plans may be postponed and some cuts in the capital expenditure budget may be done by management.

    Each company must evaluate the effect of its own economic situation on capital investment decisions. For example, a firm is planning to upgrade its equipment by buying new, state-of-the-art models that are expected to increase production. However, a new competitor suddenly enters the scene. The company must therefore postpone the upgrading plan until it is clear that the company can survive the competition.

    Growth Policies

    Not all profitable investment proposals must be accepted by management. Over-expansion or too much diversification that go beyond the controllable level may prove to be erroneous capital budgeting decisions. Capital budgeting decisions, therefore, must be made in accordance with the growth or expansion policies and organizational objectives set by management.

    Risk Evaluation

    Business risk refers to the possibility that desired outcomes may not be achieved. Unfortunately, this element of risk is always present in most capital budgeting decisions. Budgeting is planning for the future; and, therefore, the use of estimated figures cannot be avoided. As mentioned earlier, the longer the time period covered by the project, the more uncertain we are about the future and about our estimates, and the more risky the project becomes. The amount of risk involved in each capital budgeting project should be carefully evaluated because it plays a very important role in the success or failure of the projects.

    The way economic changes affect a business usually depends on the nature of the business.

    Please continue to Page 2 for more on How to Create a Capital Expenditure Budget

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    What are the other Factors that Influence Capital Investment Decisions

    In Part 2 of this article on how to create a capital expenditure budget, we see the kind of tool that can be utilized by managers in their decision making. Capital expenditures decision making must be done with with a careful analysis since the investment involved is considered a long-term project involving long-term assets. The company will obviously suffer a loss if decision making is not done well.
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    A firm selling jewelry and luxury items may experience good business during on an economic boom, while a firm selling basic commodities or staples may not be affected by such situation. These are factors to be included when you are considering how to create a capital expenditure budget.

    Availability of Funds

    Resources are scarce; therefore, the company must use them wisely. To do this, the firm may resort to capital rationing, which is the process of selecting the most desirable projects among many profitable investment alternatives. The objective is to maximize the benefits available from using scarce resources. Ranking investment projects play a vital role.

    Management, therefore, cannot just accept all seemingly profitable proposals. The availability of funds and the best way of using such funds must likewise be considered.

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    Capital Budgeting Techniques (with Illustrations) Useful in Evaluating Capital Expenditures

    There are a lot of capital budgeting techniques that can help decision makers evaluate projects but among these techniques, the most favored are those which consider cash flows and discounted at that!

    One example is the net present value method of which all cash inflows or outlfows related to the investment project are discounted at a minimum acceptable rate of return, which, in most cases, is the firm's cost of capital. The project is acceptable if the present value of cash inflows is greater than the present value of cash outflows. The difference between the two present values is called net present value. In a formula form, the computation is as follows:

    Present value of the cash inflows minus present value of cash outlows equals the Net Present Value

    or

    Present value of cash inflows minus present value of the cost of investment equals the Net Present Value

    or

    Present Value of Cash Inflows minus Cost of Investment equals Net Present Value

    The three formulas above are acceptable but the simplest computation is the third formula. We will use the third formula in our illustration below:

    Assume that Heller Company management is comtemplating the purchase of the computer with complete accessories requested by the plant engineer. The cost of the unit is $350,000. It is expected to generate cash inflows, net of income taxes in the amount of $120,000 per year during its economic life of 5 years. No salvage value is expected to be recovered at the end of the 5th year. The cost of capital is 20%.

    In this example, interest or I is 20%, and n years is 5. Let us assume that the present value factor for the expected cash inflows per year are as follows:

    1st year - 0.833

    2nd year - 0.694

    3rd year - 0.579

    4th year - 482

    5th year - 0.402

    Using these factors in multiplying the expected annual cash inflows for 5 years, $120,000, the present value of cash inflows are:

    Year Cash Inflows Present Value Factor Present Value of Cash Inflows

    1 $120,000 x 0.833 = $99,960

    2 $120,000 x 0.694 = $83,280

    3 $120,000 x 0.579 = $69,480

    4 $120,000 x 0.482 = $57,840

    5 $120,000 x 0.402 = $48,240

    Total Present Value of Cash Inflows = $358,800

    Less: Cost of Investment $350,000

    Net Present Value $8,800

    Using the results above, the investment is acceptable because the present value of cash inflows is greater than the cash outlows.

    If there is a salvage value at the end of 5 years, such salvage value is treated also as a future inflow which is added to the total cash inflows. To illustrate, if the proposal above has a salvage value of $1,000, then the total net present value of the project is $9,800 or $8,800 plus $1,000.

    In the conclusion below, it is stated that the decision maker should not rely on only one technique because techniques have their own limitations. If the two techniques discussed above cannot satisfy the need of the decision maker, another technique is utilized and this is called the profitability index.

    Profitability index is also named as present value index, desirability index, and total present value index. It is the ratio of the present value of cash inflows to the present value of cash outflows. It has the formula below:

    Profitability index is equal to total present value of cash inflows divided by the total present value of cash outflows. If the only outflow is the cost of investment, the cost of investment will be used as the divisor.

    To illustrate, for example, Heller Company has to select only one project for the moment from the two projects that are propsed:

    Please continue with this formula on Page 3 of How to Create a Capital Expenditure Budget

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    In part 3 of this article on how to create a capital expenditure budget, we learn that the ability of the manager can be assessed by looking into his prepared budget for long-term assets. He needs to be precise, careful, and critical in choosing projects.
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    Profitability Index Formula, continued

    Project A, Project B

    Cost of Investment - $20,000, $40,000

    Annual net cash inflows - $8,000, $16,000

    Economic Life - 5 years, 5 years

    Cost of Capital - 10%

    Present value factor for net cash inflows = 3.791

    If the net present values for the two projects are calculated, we shall have the following figures:

    Project A, Project B

    Present value of cash flows

    ($8,000 multiplied by 3.791 $30,328 ($16,000 multiplied by 3.791 = $60,656)

    Less: Cost of Investment $20,000, $40,000

    Net present value $10,328, $20,656

    Using the net present value method, Project B seems to be more acceptable since it is expected to yield a higher net present value than Project A. However, logic tells us that the two projects are equally attractive because the cash flows of project B are merely a multiple of two of the cash flows of project A. Naturally, large investment proposals yield large net present values, and this must be considered when reckoning how to create a capital expenditure budget.

    To have a fair comparison of the two projects, let us compute their profitability index:

    Profitability Index = Present value of cash inflows divided by investment

    Project A = $30,328 divided by $20,000 or 1.52

    Project B = $60,656 divided by $40,000 or 1.52

    Note that the two have the same profitability index and both have a profitability index of more than 1.0. It means to say that although the two projects obtain different cash flows and investment costs, they have the same profitability indexes.

    Some practitioners compute the desirability index using the net present value instead of the total present value of cash inflows. The result is called the net present value index and the formula is:

    Net Present Value index equals Net Present Value divided by the Investment cost.

    Using the data in our example above, the net present value for Projects A and B are as follows:

    Project A

    Net Present Value Index equals $10,000 divided by $20,000 or 0.52

    Project B

    Net Present Value Index equals $20,656 divided by $40,000 or 0.52

    Present Value Payback Method

    The conventional payback method determines the time required to recover the cost of investment, without regard to present value considerations. In fact, this is one of the disadvantages cited about paybacks: it does not consider the time value of money.

    To solve this problem, the present value payback method may be used. Under this method, the cash flows to be used in computing the payback period are converted to their present values. To illustrate, let us use the following data:

    Cost of Investment $100,000

    Net Cash Inflows:

    Year 1 $30,000

    Year 2 $40,000

    Year 3 $35,000

    Year 4 $20,000

    Year 5 $15,000

    Cost of Capital 6%

    The present value payback period for our illustrative case may be computed as follows:

    Year, Investment Cost To be Recovered, Net Cash Inflow x PVF, PV of Cash Inflows, Balance PV, Payback Years

    1 $100,000, $30,000 x 0.943, $28,290, $71,710, 1

    2 $71,710, $40,000 x 0.890, $35,600, $36,110, 1

    3 $36,110, $35,000 x 0.840, $29,400, $6,710, 1

    4 $6,710, $20,000 x 0.792, $15,840 - 0.42*

    Total Present Value Payback Years 3.42

    * 0.42 = $6,710 divided by $15,840

    Please continue to Page 4 for more on How to Create a Capital Expenditure Budget

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    In part 4 of this article on how to create a capital expenditure budget, we see that if this kind of tool is properly managed by a company, there is no question that it will not be competitive in its decision making, especially on matters of capital outlays.
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    Limitations of Capital Budgeting Techniques

    The net present value is good because it considers the time value of money. It considers cash flows over the entire life of the project. However, some users deciding how to create a capital expenditure budget say that the computations are quite difficult. Moreover, the computation of present values requires the use of a discount rate, such that if an overstated or understated rate is used, the evaluation would be misleading.

    The profitability index of 1.0 may be used as the cut-off point for accepting projects. A profitability index of less than 1.0 indicates a negative net present value for the project. In the case of Heller, the two projects have the same profitability index and both indexes are more than 1.0. This means to say that the company cannot use the index in comparing the two because they produce the same result. In considering only one project, then, the decision maker will have to use another method.

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    Conclusion: How will Heller Consider Projects

    As you can read in the above, it is not easy for a decision maker to choose a project from among the many proposals because projects do not have the same features like profitability and the needed human and capital resources. It is not also practical to consider more than one project at one time because of the firm's scarce resources. The decision maker, then, must use techniques to base his decisions and he must not rely only on one technique. Both quantitative and qualitative factors must be considered also. The role of a decision maker is, therefore, quite critical because of the investment that has to be poured in. The techniques presented above are both quantitative and qualitative tones but the decision maker must still use other techniques available in justifying his decision. When determining how to create a capital expenditure budget, therefore, personal judgment is also used to determine the best, appropriate decision.

    Book and Image Credits:

    Managerial Advisory Servuces, 1990 by Rodelio S. Roque

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