CAPITAL BUDGETING

I. BASIC TERMS IN CAPITAL BUDGETING

1. 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.
2. Classes of Capital Expenditures
a. Replacement investments – refers to investments on
replacement for worn-out or obsolete facilities.
b. Expansion investments – this type of expenditure will provide
additional facilities to increase the production and/or distribution
capabilities of the firm
c. Product-line or new market investments – refers to expenditures
on new products or new markets, and on improvement of old
products with the combined features of replacement and
expansion investments.
d. Investments in safety and/or environmental projects – refers to
expenditures necessary to comply with government orders, labor
agreements, or insurance policy terms; also called mandatory
investments or non-revenue producing projects.
e. Strategic investments – investments designed to accomplish the
overall objectives of the firm.
f. Other investments – this catch-all term includes office building,
parking lots, executive aircraft.
3. Capital Budgeting – the planning and control of capital expenditures;
this activity is essential because it provides a systematic evaluation of
the firm’s alternatives. It helps management in choosing an
alternative that will provide the best yield for the company.
 4. Valuation – management is, at times, confronted with the problem
of evaluating a proposal. When the proposal’s real worth to the firm
is determined, the process is called valuation.
5. Investment – this is made when a firm spends some of its funds for
the establishment of a project.
Two Forms of Investment:
a. Initial – refers to the amount that has been devoted to a project
until it generates cash inflows from operations.
b. Later – expenditures made after the first cash inflow.

II. OBJECTIVES OF CAPITAL BUDGETING (ECCER)

1. Establishing priorities – since resources of the firm is limited and the
total number of opportunities available for investment cannot all be
accommodated by the firm, capital budgeting is used to solve this
difficultu by prioritizing investments.
2. Cash Planning – since availability of funds is the objective of cash
planning, to enure that these funds will be sufficient to meet the cash
requirements including acquisition of capital assets, a periodic cash
expenditure estimate helps to attain this objective.
3. Construction Planning – since the objective of construction planning
is to minimize the period expended for the construction or
acquisition of a capital asset, this construction plan should be made
before the capital budget is prepared.
4. Eliminating Duplication – a centralized capital budgeting activity will
help identify efforts undertaken at various levels ina decentralized
organization. The duplication efforts, as a result will be minimized if
not totally eliminated.
5. Revising Plans – good capital budgeting system will be a timely
response to changes in the environment factors that may require
appropriate revisions in the authorization of investment projects
which include expected profitability, construction cost, and the
timing of start-up, where coordination with related activities is
essential.
III. THE CAPITAL BUDGETING SYSTEM
Composition:
1. Preparation and Submission of Budget Requests
2. Approval of Budget
3. Request for appropriation
4. Submission of progress reports
5. Post approval reviews

A. Budget Requests – those made to include in the corporate budget

capital projects which are felt to be desirable by those in the
lower organizational levels.
It contains the ff:
a. Project title
b. Cost, including estimates on: fixed capital, working capital,
non-operating outlays, others, including opportunity cost
c. Priority rating of the project
d. Profitability of the project
e. Timing or the ability to adhere to a construction schedule
f. Financing method
g. Project classification
h. Project narrative
B. Approval of the Budget – is a process which requires the following
steps:
a. Budget requests are forwarded to top management
b. Top management decides which projects to recommend to the
board of directors
c. Top management sends recommendations to the board of
directors
d. The board of directors approves or disapproves the
recommendations; and
e. Top management informs projects sponsors of the action
taken on their projects
C. Request for Appropriation – here the officers and managers of a
corporation are usually given the authority to approve
appropriations requests up to certain established limits.
The request usually contains:
a. The request and authority section – serves to identify the
originator and the project;
b. The narrative section – this details the requesting entity’s
justification for undertaking the proposal. This includes the ff.:
b.1. proposal
b.2. objectives
b.3. conceptual framework
b.4. alternatives
b.5. sensitivity and risk.

c. Supporting documentation section – this contains cost

estimates and the results of market studies and financial
analysis.
D. Submission of Progress Reports – submitted at regular intervals
for the ff.: purposes:
a. To review the accuracy of the expenditures forecasts
b. To provide updated expenditures forecasts, and
c. To verify the assumptions and economics underlying the
acceptance of individual projects.
E. Post Approval Reviews – required to satisfy the ff.: objectives
a. To provide management with a standard method of evaluating
the abilities and judgement of project sponsors
b. To identify errors or patterns of error in judgment which can
be avoided in future similar situations, and
c. To help ensure that the quality and accuracy of information
attains the highest feasible standards.
IV. EVALUATION OF PROPOSED CAPITAL EXPENDITURES
Primary factors needed in scrutinizing proposed capital expenditures:
(INCURR)
1. Investment Worth – refers to the economic evaluation of a certain
proposal.
2. Non-Economic Factors – refer to social considerations, and other
non-economic persuasions and preferences.
3. Credit – should be considered in the sense that some credit terms
may be highly favorable to the company.
4. Urgency – decisions should be made as quickly as possible for
requirements that are urgent.
5. Repairs – management should consider the availability of spare
parts and maintenance experts. When these are critical and they
are not available, the concerned proposal should be ruled out.
6. Risk Involved – refers to the uncertainty of an expected return.
V. METHODS OF ECONOMIC EVALUATION
1. Capital investments need to be analyzed and a determination of their
economic value to the firm should be made.
2. There are three basic methods of evaluating proposals:
a. The Payback Method – determines the number of years required
to recover the cash investment made on a project. The recovery
of cash comes from the cash inflows generated from the project.

Formula: COST_______
Annual Cash Inflow
Substitution:
Payback Period = P 10,000,000
P 2,380,000

= 4.2 years
Interpretation:
 The cost of the machinery is expected to be recovered in full
after 4.2 years. When the firm does not favour exposure of its
own investments for longer periods, the proposal is rejected.
Disadvantages of Payback method:
a. It does not consider the time value of money
b. The accept-reject criterion is stated in terms of years rather
than at a discount rate
c. The firm’s attention is focused on cash flowed rather than on
rate of return
d. Careful projection of the timing of the investment outlays and
the year-by-year projection of cash inflows over the entire life
of the proposal are not encouraged, and
e. The salvage value of the proposal is not considered.
b. The Average Rate of Return Methods – consists of the ff.:
a. Average Return on Investment – simple and easy to compute;
shows the ratio of the average cash inflow to the investment.

Formula :
Average return on investment = Annual Cash Inflow
Investment Outlay
Substitution:
Average return on investment = P 2,380,000
P 10,000,000
= 24%
The advantage of this method is that it is very easy to compute
and the available accounting data may be readily used. Its
main disadvantage, however, is that it does not take into
account the time value of money.
b. Average Return on Average Investment – this method is
similar to the average return on investment method except
that the effect of the depreciation charge on the investment is
taken into consideration.
 Formula: Average Return
On Average = Annual cash inflow
Investment Investment / 2

Substitution :

Average Return on Average = P 2,380,000

Investment P 10,000,000 / 2

= 48%
Under this method, the initial investment outlay is divided by
two to derive the average balance of the investments as it is
decreased periodically by the depreciation charge. The true
rate of return is overstated and it does not also consider the
time value of money.
c. Discounted Cash flow Methods – recognizes the time value of
money. (Research and write in your notebook)