CAPITAL BUDGETING

Introduction

Reporter :
Jessica M. Bongulto
Learning Objectives:
Understand the meaning of capital investment decisions and its
importance in business operations.
Define Capital Investment or Capital Budgeting.
Understand the objectives of Capital Budgeting.
Know different project classifications.
Describe the typical capital budgeting approval process.
Know the different capital budgeting screening or ranking criteria.
Explain the importance of the time value of money in capital
budgeting.
Compute the future value and present value of cash flow
occurring over several time periods.
Introduction

Is choosing the
assets in which an
organization will invest.
Capital assets consist of assets that are
used to generate future revenues or cost
savings by providing production,
distribution, or service capabilities for
more than one year.
Capital Budgeting is a process for
evaluating an economic entity’s proposed
long-range projects or courses of future
activity for the purpose of allocating
limited resources to desirable projects.
Importance of Capital Budgeting
Long-term
goals

Monitoring & Involvement

Controlling Capital Large
the Budgeting amount of
Expenditure funds

Irreversible
Decision
Project Classification
• Replacement: maintenance of businesses
This category consists of expenditures necessary
to replace worn-out or damaged equipment used
to produce profitable products.
• Replacement: cost reduction
This category includes expenditures to replace
serviceable but obsolete equipment. The purpose
of these expenditures is to lower the cost of
labour, materials, or other items such as electricity.
• Expansion of existing products or markets
This category includes expenditures to increase
output of existing products, or to expand outlets or
distribution facilities in markets now being served.
• Safety and environmental projects
This category includes expenditures necessary to comply
with government orders, labour agreements or insurance
policy terms. These expenditures are often called
mandatory investment, or non-revenue producing projects.
• Others
This catch-all category includes office buildings, parking
lots, executive aircraft, and so on.
Basic Objectives of Capital Budgeting

• Primary Objective

Financial managers utilize funds of the

company within the limits of his authority so
that over the long run, the company receives at
least as high a rate of return on its investment as
might be obtained.
• Secondary objective

is the maximization of the present-value of

resource investment to obtain as high a return
as possible without assuming undue risks.
The Capital Budgeting Process
Capital budgeting process determine the
allocation of funds in order of priority. It is a set
of systematic capital budgeting procedures
necessary to ensure that all capital investment
proposals are evaluated considering the
organization goals and policies so that the best
or the most acceptable alternative taken.
1 2 3
• Identification of • Estimation of cost • Determine the
potential process and benefits riskiness of the
projected cash flows

4 5 6
• Development of the • Development of • Re-evaluation of
project proposal capital budget projects
Factors Affecting Capital Budgeting Decision

• The amount of cash outflows related to the

investments.
• The expected cash flow returns (inflows) on
the investments.
• The lowest acceptable rate of return the
company has to set before considering
analyzing capital investment or hurdle rate or
the minimum desired rate of return.