Planning and Controlling Capital Expenditures - Essay Example

? of the due: Planning and Controlling Capital Expenditures Capital Expenditures According to Nice(2002), Capital expenditures imply outlays of cash that are mostly needed to upgrade a business asset. Capital expenditure can sometimes be referred to as capital spending or capital expense. Many public traded companies always list their capital expenditure annually in annual reports, with the aim that stockholders can see how the company is spending its money in planning long term decisions. Thus most companies hold on capital expenditures every year, in an attempt to continuously upgrade and improve things like facilities, vehicles, buildings and equipment. A capital expenditure is considered deductible since it represents an improvement to the business and this deducted takes place over a specific life of an item, after than all at once as in the case of repair or maintenance expenditures. Sometimes it is cumbersome to determine the difference that exists in capital expenditure and a routine expense. Generally capital expenditure improves the worth of an asset while if it keeps the asset in working condition, it is referred to as routine expense. Hence, engaging in capital expenditure is a routine way of upgrading and expanding business whether done on a small scale or on a large scale (Pike and Neale, 2003). Large firms or corporations may acquire extra companies, as in the case of automotive giant which purchases another car manufacturer. Consequently, allowances are made in the budget of the company for the capital expenses, including the ones involving the replacement of items which are no longer repaired. Capital expenditures thus normally yield benefit over a long period of time resulting into fixed assets. The resource constraint is a frequent phenomenon of all the economic activities in business. In addition, when a firm is able to spend on specific items it is not willing to do so (Nice, 2002). Therefore, a systematic screening is established to accept or reject the investment proposal. Investment proposal are divided into two groups that is: Mutually exclusive proposals and independent proposals. Mutually exclusive proposals are proposals that have an alternative of doing the same thing. If one alternative is selected then the other one must be rejected for example: if in plant material facilities are required, they are grouped according to their economic benefits. The economic benefits of each of the proposal will be evaluated and the one with the contributing maximum economic benefits is chosen while the rest with less economic benefits are rejected (Pike and Neale, 2003). Independent proposals are those items of capital expenditures that are always considered for different types of projects whose accomplishments are highly needed. In this case all independent proposals are independent of each other and are worthy for implementation. However, due to financial difficulties, priorities are assigned to each proposal according to the gravity of the need of the organization for example: in line with the material handling equipments, instruments such as machines for weighing, packing, stamping may be required(Cotts, 2007). Thus for mutually exclusive proposals the decision criterion is accept or reject while for independent proposals the decision criterion is mainly based in ranking. The decision taken is based on the methods of analyzing the capital budgeting decisions. The environment of capital expenditure proposals are widely grouped into: Expansion, Replacement, Diversification and Strategic proposals. Expansion proposals involve the capital expenditure to boost the production capacity within the same line of production (Shah, 2007).The investments are basically made in the familiar areas of activity as it involves minimal business risk as compared to diversification, however, larger risk than replacement expenditure. Replacement capital expenditure implies replacement of old machinery by a new one or a modern one. This replacement only becomes necessary when there is wear and tear or due to obsolescence. This results into more production and reduction in operating costs. This therefore helps in the reduction of unnecessary expenses that might be incurred as a result of the old machinery in the organization (Pike and Neale, 2003). Therefore, as investments are made in the same line of production, the business is not exposed to a larger amount of risks. In diversification proposals capital expenditures are made in a new line of production. In this case such business are greatly exposed to larger amount of risks due to the fact that at that time there is no enough familiarity of the production and sales area of the business itself. According to Cotts (2007), strategic proposals in capital expenditure are those proposals that indirectly contribute to the revenues. Such like investments can have the following characteristics: Investments in plant services such as storage facilities, material handling. Personal services investments such as investments for provision of canteen, office-air-conditioning and parking area. Advisements campaign expenditure and expenditure on marketing securities. Belkaoui (2001) explains that in the planning and controlling of capital expenses cash flows are the most important point of analysis. Cash flows out of investments are careful rather than accounting profits created out of the investments. The profit from accounting and the cash inflow do not show the similar figures since, cash inflow is the surplus of cash receipts while accounting profit is a sporadic profit ascertained depends on the accumulation principle of accounting involving particular adjustments such stipulation for depreciation on fixed assets diminish the accounting profits, yet it is not an actual outflow of cash. In this case, cash flows are well thought-out rather than the accounting profits since, for the reasons of making extra profits an entity must reinvest and there is no assurance that one will have the accountants’ statement of profits ready in the form of cash. Ways of planning and controlling capital expenditures According to Shah (2007), Planning and controlling correlate with each other and are consecutive steps for the prosperity of any financial project. Planning conducted for any acquiring capital expenses is followed via control devices to evaluate the variances that exist between anticipated and the achieved results. Therefore, control for capital spending is shown in line with the above objective. Today large amount of finance is held up as capital expenditure in most business enterprises. The proportion of capital expenditure is very huge in utility industries such as oil and gas. In addition, in service industries and small businesses have always incurred a lot of capital expenditure without justification. Capex planning is a complex process that is always involving considerable levels of expenditure and great exposure to risk. Large capacity projects such as these have got the propensity to off the rails. This situation is encouraged in the planning stage by spreadsheet bound procedures which are subject to error and do not afford sufficient opportunities for collaboration between financial and technical specialists (Shah, 2007). Nevertheless, a new breed of alternatives is emerging, which building on thriving web based implementations of more straightforward budgeting and forecasting applications, gives the specialized functionality significant for the Capital expenditure planning combined with guided workflow and process support. These techniques grant the capability to plan for a large Capital spending in a mutual background which guarantees that financial and technical plans are inextricably connected covering all phases of an assets’ valuable existence from planning and manufacture through safeguarding and decommissioning (Cotts, 2007). In this situation, operational affairs are automatically shown in financial results and management can judge the impact of a range of scenarios on taxes, cash flows and anticipated balance sheets straddling several years. But alliance on this capacity also brings return in a more tightly controlled approval process with better visibility for those making choices and quicker decisions. Capital expenditure exists in three types: that is, expense made to reduce costs, to increase revenue and expenditure which is acceptable on non-economic grounds. With implemented control over capital expenditure, assessment should focus on three types of outlays that is, chief projects, overheads on routine activities and substitute proposals (Belkaoui, 2001). In addition key projects, considered investments may be prepared for the purposes of expansion of helpful capacity or targeting manufacture innovation or preparing hindrances against capital fluctuations. In the second outlay, routine spending may be working condition improvement, competition expenses and repairs expenditure. Finally the significance for replacement might be obligatory to keep away from needless wastage for existing equipment. Therefore, in all circumstances proper focus is to be committed in assessing the relevance for the capital expense for it to be curtailed for the shorter period required. Conversely, one important facet of control device in capital expenditure is to make the demand and supply schedule of capital from different sources equivalent. Demand emanates for capital from entire departments and it is at this stage control can be practiced to maintain the demand at the bare minimum from all departments needed for the objective intrinsic in capital venture choices. Capital supply, on the other side, is a seldom commodity and the organization has to incur the expenditure for availing it (Belkaoui, 2001). Therefore, the finance manager should exercise economy in capital expenditure so as to obtain optimum benefit with the presence of scarce capital sources that are readily available. This also creates the basis of rationing capital to enforce constraints on capital spending under existing market environment so as to introduce self-imposed constraints to assess the funds being raised fro external agencies like borrowings. Hence, capital rationing is a very important tool in controlling capital expenditure. Planning and controlling Capital expenditure also includes some aspects of budgeting that are very important. Since many companies strive to make a lot of profits through the efficient and economic use of the limited resources and laboring this case they also need financial road maps in order to locate how they will distribute their resources according to achieve their business objectives (Shah, 2007). Therefore, companies should practice budgeting thus helping in the estimation of probable capital expenditures and income for a duration of time. Budgeting allows organizations to control their expenditures and as well assist them in proper planning on how they to utilize the available resources. Consequently, since budgeting is an important tool of controlling and planning for capital expenditures then capital expenditures budgets are majorly used to elaborate major investments goals often over a period of 5 to 10 years. Companies majorly depend on capital budgeting in order to plan, evaluate, identify and finance the main investment projects whereby it converts short term assets into long term assets. The organization uses these new assets to like robotics, computers and modern equipments for greater productivity, increase market share and boost profits (Shah, 2007). A company purchases these new assets to holding cash since it believes that in the long run these assets will bring great wealth to the business more rapidly as compared to cash balances thus capital expenditures budget is very essential to the overall budgeting process. Capital budgeting helps to make decisions in the present that show, to a large dimension, how successful an organization will be meeting its goals and objectives in the future. Capital expenditure budgets have the following features: According to Pike and Neale (2003), Capital expenditures need relatively large amounts of resources whose dollar value may exceed annual net inflow. They also extend beyond one year planning zone as compared to other financial budgets. To replace old equipment may take year and 6 months while to build a new plant could involve years of planning and construction. Capital expenditures include greater operation risks. A company experiences more difficulties in the long term projecting of revenues, cost savings and expenses. Moreover, Capital expenditures increase the financial risks by including long term liabilities. An organization’ short term liabilities, in the form of bond interest, increase long prior to the project becoming an earning asset to the organization. Capital expenditures entail comprehensible policy decisions that are in full accord with the company's objectives since a company has less suppleness to modify or revoke a project in progress without serious potential cost. As priorly discussed, a capital expenditure is a financial outflow for a particular plan that is expected to give a flow of money over certain duration usually more than a year. Due to the fact that capital expenditure can involve huge sums of money and have significant force on the financial feat of the firm, it is essential to focus on the best project selection criterion. This process is known as capital budgeting (Pike and Neale, 2003). Potentially, there exists a wide array of criteria of project selection. Some shareholders may want to emphasize long term growth with less significance on the short term performance while others may select projects that will show immediate heave in cash inflow. Viewed from this perception it would be cumbersome to fulfill the interests of every one. Nevertheless there is a solution and since the goal of the firm is to maximize present share holder value. This goal therefore, implies that projects should be chosen that result in a positive net present value .This implies that the present value of the expected cash inflow less the present value of the required capital expenditures (Pike and Neale, 2003). Using the NPV as a measure, capital budgeting entails selecting only the projects that increase the value of the firm since, they have a positive NPV. The timing and the rate of growth of the cash inflow is significant only to the extent of its impact on net present value. Using net present value as the criterion of selecting projects assumes efficient markets so that the firm has accessibility to whatever capital is required to pursue the positive NPV projects (Cotts, 2007). In circumstance whereby this is not the case, there may be capital rationing and hence, capital budgeting becomes hectic. Vividly the Net Present Value computes the distinction between present worth of future money inflows produced by a plan and money outflows during a particular duration time. With the aid of NPV it is easy to figure out an investment that is likely to breed positive cash flows (Pike and Neale, 2003). When estimating the net present value, we initially approximate the anticipated future money flows from a plan in concern. Then we obtain the current worth of these money flows by using the discounted cash flow (DCF) valuation measures (Nice, 2002). Eventually, when we have the estimated figures then estimation of NPV is done on the differentiation involving the current worth of the incoming cash flows and the rate of investment at hand. The formula for calculating the net present value (NPV) is Npv=CFt/ (1+r) t-Cfo Thus Net Present Value=current value of future money inflows- investment cost. In addition to this formula, tools like spreadsheets and tables can be used to work out the net present value. A potential investment must be selected the Net Present Value shows a positive feedback and rejected if it is showing negative feedback. For example consider the following, A rate of return of 12% and a net present value of 80,452 dollars, it is calculated by discounting the yearly net cash flows and a rescue value with the 12% reduction factor. Therefore, the company has equal net cash flows of $50,000($250,000cash receipt-$200,000operating expenses).So the current worth of remaining money flows is calculated by using the present value annuity of 1 for 7 periods. The factor is 4.57 using 12% discount rate while the current worth of the remaining flow of money is 228,190 dollars. The salvage value is received only once in the 7 periods and its value is $2,262 which is computed using the preset value table 1 factor for the 7 periods and 12% discount rate factor of 0.452 multiplied by $5000 salvage value. The 150,000 does not need to be discounted since it’s currently in dollars that is a factor value of 1.000.therefore, in obtaining the net current value, the venture is subtracted from the current worth of the total incoming cash flows of $230,452.hence in this case the net present value is positive showing a positive feedback on investment project. Present value of 1 time 2.0% 4.0% 5.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0% 1 0.980 0.960 0.952 0.943 0.930 0.909 0.892 0.877 0.862 2 0.960 0.930 0.907 0.890 0.857 0.826 0.797 0.769 0.743 3 0.942 0.889 0.864 0.840 0.793 0.751 0.711 0.675 0.640 4 0.924 0.855 0.823 0.792 0.735 0.683 0.635 0.592 0.552 5 0.906 0.823 0.784 0.747 0.680 0.620 0.567 0.519 0.47 6 0.888 0.790 0.746 0.705 0.630 0.564 0.506 0.455 0.410 7 0.871 0.760 0.711 0.665 0.583 0.513 0.452 0.399 0.353 8 0.852 0.731 0.677 0.627 0.540 0.540 0.403 0.350 0.305 9 0.837 0.703 0.645 0.592 0.500 0.424 0.360 0.307 0.263 10 0.821 0.676 0.614 0.558 0.463 0.385 0.322 0.269 0.226 (Belkaoui, 2001) Cash Outflows Incoming Cash Flows $250,000 Cost of the project $150,000 Cash from customers Operating costs 200,000 Salvage value 5,000 Estimated duration(yrs) 7 Minimum required rate of return 12.0% Yearly net cash flows $50,000.00 (Belkaoui, 2001) Value Of current money Flows Yearly net cash flow(50,000x4.57) $228,190 Salvage value(5,000x0.452) 2,262 Total present value of the incoming cash flows 230,452 Subtract: investment cost (150,000) NPV $80,452 In circumstances whereby the net cash flows are not similar, a break up current value computation must be made for each and every time of cash flow (Belkaoui, 2001). Assume he same project information for the company’s investments except for the remaining cash flows which are reviewed with their current value estimations as shown below. Time anticipated annual net cash flow 12.0% discount factor(2) Present value 1 44,000 0.883 39,288 2 55,000 0.798 43,846 3 60,000 0.712 42,708 4 57,000 0.636 36,224 5 51,000 0.567 28,937 6 44,000 0.507 22,290 7 39,000 0.452 17,640 Totals $350,000 $230,933 Therefore, the NPV of the project is calculated as follows: current value of the incoming cash flows Yearly net cash flows $230,933 Salvage value(5,000x0.452) 2,26 Total present value 233,195 Less: cost of investment (150,000) NPV $83,195 Eventually the difference between the NPV under similar cash flows example, $50,000 per year for a span of 7 years or 350,000 dollars and the uneven cash flows of $350,000 spread unequally over a period of 7 years. Many organizations expected rate of return is their cost of capital. Charge of capital is the charge which the corporation could obtain capital finances from its shareholders and creditors (Cotts, 2007). In case there is risk involved when estimating cash flows into the future, some firms put in a risk feature to their capital cost to recompense for improbability in the project and in cash flows as well. Most organizations have more project plans than they do funds available for projects. In addition, they also have projects that need unusual quantity of capital and with unlike net present values. When comparing different proposals for possible approval, corporations apply a profitability indicator (Cotts, 2007). This indicator separates the current worth of cash flows the investment in need at that specific time. Thus according to the calculations above, the companies profitability indicator of the venture with equivalent cash flows is1.54 and that of the project with uneven cash flows is 1.560. Net present Value is one of the most common methods of controlling capital expenditures and also knowing the right project to invest on, others include internal rate of return and payback period.NPV and IRR techniques for project assessment results to unclear results in the following situations (Belkaoui, 2001). The pattern of cash inflows has an important part in project evaluation while using IRR method that is; the cash flows of one plan may raise over time, while the rest may diminish and so on. The main draw back with IRR method is the one for jointly exclusive plans; it can give conflicting venture criterion when match up to NPV. Consider the following example: year Project A ($) Project B ($) 0 (1000,000) (1000,000) 1 75,000 600,000 2 275,000 575,000 3 450,000 75,000 4 500,000 ---- 5 525,000 ----- IRR 19% 15% NPV $198,349.87 $250,000.00 Conversely, in the above cases projects A and B are jointly exclusive jobs. Therefore, the two projects require an initial cash cost of 1,000,000 dollars but the cash flow prototype is different. Considering plan A, its cash flows are rising over the duration of time while for B these are dropping. IRR decision decisive factor leads to choose project A. But decision based on NPV analysis shows that project B is more useful as compared to A (Belkaoui, 2001). Therefore, based on IRR the company may choose a less profitable proposal. Consider the following example: Year Project A(‘000’) Project B(‘000’) 0 (1000) (700) 1 300 525 2 275 (175) 3 300 350 4 500 (75 5 200 500 IRR 17% 19% NPV $117.736 $102,155 Project A requires a cash outlay at the beginning of the project while B a cash outflow in year two and year 4.Decision based on IRR methods approves project B but NPV of project B is less than that of project A, thus under such situations IRR plays a deceive role. Therefore, the timings and pattern of cash flows can produce conflicting results in the NPV and IRR methods of proposal evaluation as used in controlling capital expenditure (Belkaoui, 2001). Generally, IRR is a method of analysis with limitations and requirements for its use.Since; it does take into account for risk, time value of money and other important considerations like opportunity costs. References Nice, D. C. (2002): Public Budgeting. Belmont, CA: Wadsworth/ Thomson Learning. Shah, A. (2007): Budgeting and Budgetary Institutions: Public Sector Governance and Accountability Series. New York: Oxford University Press. Cotts, D. G. (2007): Facility manager's guide to finance and budgeting. S.l.: Amacom Books. Pike, R., & Neale, B. (2003): Corporate finance and investment: decisions and strategies (4th Ed.). Harlow u.a.: Financial Times Prentice Hall. Belkaoui, A. (2001): Evaluating Capital Projects. Westport, Conn: Quorum Books. Read More