3. Capital Expenditures – refers to
substantial outlay of funds the purpose of
which is to lower costs and increase net
income for several years in the future.
Classes of Capital Expenditures:
• Replacement investments - investments
on replacement of worn-out or obsolete
facilities.
• Expansion investments – this will
provide additional facilities to increase the
production and/ or distribution capabilities
of the firm
Basic Terms in Capital Budgeting 3

4. • Product-line or new market investments
– expenditures on new products or new
markets.
• Investments in safety and/ or
environmental projects – these are
necessary to comply with government
orders, labour agreements, or insurance
policy terms.
• Strategic Investments – these are
designed to accomplish the overall
objectives of the firm.
• Other Investments – this includes office
buildings, parking lots, executive aircraft.
Basic Terms in Capital Budgeting 4

5. Capital Budgeting – is referred to as the
planning and control of capital expenditures.
Valuation - is the process of estimating
what something is worth.
Investment – this is made when a firm
spends some of its funds for the
establishment of a project.
Basic Terms in Capital Budgeting 5

7. Objectives of Capital Budgeting
1. Establishing Priorities – investment priorities are
established in capital budgeting
2. Cash Planning – to ensure the availability of funds
that will be sufficient to meet its cash requirements
3. Construction Planning – to minimize the period
expended for the construction or acquisition of a
capital asset
4. Eliminating Duplication – to minimize the
duplication of efforts.
5. Revising Plans – changes in environmental factors
may require revisions in authorization of investment
Objectives of Capital Budgeting 7

9. The Capital Budgeting System
1. Preparation and Submission of Budget
Requests;
2. Approval of Budget;
3. Request for Appropriation;
4. Submission of Progress Reports; and
5. Post Approval Reviews
The Capital Budgeting System 9

10. The Capital Budgeting System:
Budget Requests
• Budget Requests are those made to include in the
corporate budget capital projects which are felt to be
desirable by those in the lower organizational levels.
The budget request contains the following:
1.Project Title;
2.Cost, including estimates on;
• Fixed capital
• Working capital
• Non-operating outlays
• Others, including opportunity cost;
The Capital Budgeting System 10

11. The Capital Budgeting System:
Budget Requests
3. Priority rating of the project;
4. Profitability of the project;
5. Timing or the ability to adhere to a
construction schedule;
6. Financing method;
7. Project classification; and
8. Project narrative
The Capital Budgeting System 11

12. The Capital Budgeting System:
Approval of the Budget
• Steps for the Approval of the Budget
1. Budget requests are forwarded to top
management;
2. Top management decides which projects to
recommend to the board of directors;
3. Top management sends recommendations to the
board of directors;
4. The board of directors approves or disapproves
the recommendations; and
5. Top management informs projects sponsors of
the action taken on their projects.
The Capital Budgeting System 12

13. The Capital Budgeting System:
Request for Appropriation
The appropriations request usually contains the following:
1. The request and authority section – this serves to identify
the originator and the project;
2. The narrative section – this details the requesting entity’s
justification for undertaking the proposal.
• Proposal;
• Objectives;
• Conceptual framework;
• Alternatives; and
• Sensitivity and risk
3. Supporting documentation section – this contains cost
estimates and the results of market studies and financial
analysis.
The Capital Budgeting System 13

14. The Capital Budgeting System:
Submission of Progress Reports
Progress Reports are submitted at regular
intervals for the following purposes:
1. to review the accuracy of the expenditure
forecasts;
2. to provide updated expenditures forecasts;
and
3. to verify the assumptions and economics
underlying the acceptance of individual
projects.
The Capital Budgeting System 14

15. The Capital Budgeting System:
Post Approval Reviews
Post approval reviews are required to satisfy the
following objectives:
1. to provide management with a standard method of
evaluating the abilities and judgement of project
sponsors;
2. to identify errors or patterns of error in judgement
which can be avoided in future similar situations;
and
3. to help ensure that the quality and accuracy of
information attains the highest feasible standards.
The Capital Budgeting System 15

17. Proposed capital expenditures should be scrutinized since
they involve large outlay of funds. A number of primary factors
should be considered by management. These are the
following:
1. Urgency. Decisions should be made as quickly as
possible for requirements that are urgent.
2. Repairs. Management should consider the availability of
spare parts and maintenance experts.
3. Credit. This factor should be considered in the sense that
some credit terms may be highly favorable to the
company.
4. Non-Economic Factors. These refer to social
considerations and other non-economic persuasion and
preferences.
5. Investment Worth. This refers to the economic evaluation
of a certain proposal.
6. Risk Involved. This refers to the uncertainty of an
expected return.
Evaluation of Proposed Capital Expenditures 17

19. Methods of Economic Evaluation: The 19
Payback Method

20. The Disadvantages of Payback Method:
1. it does not consider the time value of money;
2. the accept-reject criterion is stated in terms of
years rather than at a discount rate;
3. the firm’s attention is focused on cash flow rather
than on rate of return;
4. 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
5. the salvage value of the proposal is not
considered.
Methods of Economic Evaluation: The 20
Payback Method

21. Methods of Economic Evaluation: The 21
Average Rate of Return Methods

22. Methods of Economic Evaluation: The 22
Average Rate of Return Methods

23. DISCOUNTED CASH FLOW METHODS
The time value of money is recognized under the
discounted cash flow methods. There are two
approaches available:
(1) The Net Present Value Method; and
(2) The Internal Rate Of Return Method.
Under these approaches all future values of a
proposal are discounted and compared to the
values of other proposals. The discounting factor
makes these two methods preferred by users in
evaluating capital expenditure proposals.
Methods of Economic Evaluation: Discounted 23
Cash Flow Methods

24. Net Present Value Method
Under this method, a desired rate of return is used
for discounting purposes. The present value concept is
applied to the cash flows of a proposal and are
discounted at the desired rate of return for the periods
involved.
NPV = PVCI – PVCO
where NPV = net present value
PVCI = discounted value of the anticipated cash
inflows
PVCO = discounted value of the anticipated
cash outflows
Methods of Economic Evaluation: Discounted 24
Cash Flow Methods

25. Methods of Economic Evaluation: Discounted 25
Cash Flow Methods

26. Internal Rate of Return Method
Under the internal rate of return method, the discount rate
is not given. Rather, it becomes the object of computation. The
discount rate which will yield a net present value of zero or one
approximating zero is the correct discount rate. This means
that the present value of the cash inflows is equal to the
present value of the cash outflows. The correct discount rate
may be determined by trial and error.
a. NPV at 22% discount rate= PVCI–PVCO
= ₱9,350,800–₱10,00,000
= -(₱649,200)
b. NPV at 21% discount rate= PVCI–PVCO
= ₱9,603,520–₱10,000,000
= -(₱396,480)
c. NPV at 20% discount rate = PVCI–PVCO
= ₱9,994,080–₱10,000,000
= -(₱5,920)

28. MEANING OF RISK, UNCERTAINTY AND
SENSITIVITY
Risk is defined as the uncertainty concerning loss.
Uncertainty, as a term is synonymous to risk, and as
such, they will be used interchangeably in the
discussions that will follow. Uncertainty and risk both
refer to variations of actual values from average or
expected values. The variations referred to in risks is
caused by chance, while the variations referred to in
uncertainty is caused by errors in estimating.
Sensitivity refers to the effect on investment of
changes in some factors, which were not previously
determined with certainty.
Risk, Uncertainty and Sensitivity 28

29. FACTORS AFFECTING RISK
There are four primary factors involved in the evaluation
of risks pertaining to capital expenditures. These are the
following: (1) possible inaccuracy of the figures used in the
evaluation; (2) type of business involved; (3) type of physical
plant and equipment involved; and (4) the length of time that
must pass before all the conditions of the evaluation become
fulfilled.
Estimates could be wrong or inaccurate at times.
Accuracy, however, depends on how the figures were
obtained. Estimates can be made either by scientific methods
or by plain guesswork.
Every type of business has its own degree of risk that is
peculiar to itself. The demand for foo, for instance, is more
stable than the demand for specialized consumer items like
hair dyes. More risk is involved in the operations of a new
venture than a business with a successful record of past
performance. Risk, Uncertainty and Sensitivity 29

30. Physical plants and equipment are also subject to
risks. Some may become obsolete before their
economic life expires. The demand for special
equipment like that for DVD players, may diminish
without warning.
Estimates involving longer periods are usually more
prone to inaccuracies than those involving shorter
periods. This is true because, most often, changes in
the environment happen sooner than expected.
Risk, Uncertainty and Sensitivity 30

31. SENSITIVITY ANALYSIS
Sensitivity analysis is applicable to capital
expenditures involving the purchase or construction of
a plant. It is useful for management to know the
expected returns that will be generated by the various
capacity utilization in the operation of the plant.
Risk, Uncertainty and Sensitivity 31