ArtsAutosBooksBusinessEducationEntertainmentFamilyFashionFoodGamesGenderHealthHolidaysHomeHubPagesPersonal FinancePetsPoliticsReligionSportsTechnologyTravel

Managerial Accounting - Capital Exepnditure Decisions

Updated on December 29, 2010

Technological advancements are forcing companies to scapped their old and obsolete assets and replace them with more efficient ones. Average machines life has reduced to 5-7 years. But this pays off as the new machines are cheaper to buy and more productive thereby recouping their cost in much lessor times than before. This fits into definition of technology which hovers around 'cheapest, quickest and easiest'.

In a capital expediture decision, a most important factor is size. The degree of risk is closely linked with the magnitude of the investment.

Capital Expanditure (Capex)

The term Capital Expenditure means long term investment in fixed assets. In turn, fixed assets mean property, plant and equipment (PP&E). These are to be used for further production and are not for sale. Whether a particular assets can be classified as fixed or current depends upon nature of the business. A power generator for a sugar plant would be a fixed asset whereas the same generator for the machinery supplier would be a part of stock and therefore a current asset.

What is a capital expenditure?

It is an expenditure with the aim of getting benefits in future. It applies not only to invesment in fixed assets but to related cost such as payment of custom duties, clearance and forwarding, erection and installation, markup during construction and trial runs.

Capital expenditures are incurred to setup greenfield project or to upgrade brownfield projects. It also cover Trophy projects which just boost image of the company. The manufacturers are paying due attention to their social responsibilities and are investing in such projects which reduce polution, increase safety within the factory and improve quality of life in the neighborhood through opening schools, hospital and recration facilities.

Type of Finances

Like type of projects, there are type of finances. Most common is commercial finance. The financier, usually a commercial bank, insists on security or collateral before hand. The bank either takes the security in its possession like shares, bonds & inventories or creates a charge over the assets. Once this is done, there is hardly any need for loan supervision.

Project finance differs from commercial finance. It is not based on security but on cash flow of the project. That is why a feasibility of the project is carried before any finance could be extended. The bank has a charge over the project's assets but these are all custom made and have very low market value. Therefore, the banks make certain that the project is viable. Even after disbursement of funds, the bank keeps an eye on the project through its system of surveillance.

Development finance is an off-shoot of project finance. It is concessionary and available only for priority sectors and also only for fixed capital investment. (Commercial finance is mostly used for raising current assets).

A simple example of two proposals

Mr. Kabeer desires to go for manufacturing. He has about Rs.15 million. Presently, he is concentrating on two projects: (i) Weaving mills & (ii) Oil Plant. Both projects require equal investment of Rs.10 million each and would generate an income as detailed in the table. Both projects have a four-year life with no salvage value at the end.

No other information is available except that the owner wants a return of at least 12% per annum. If so, which project should be selected.

Year 
Weaving Plant 
Oil Mills 
(10,000,000 )
(10,000,000) 
1,000,000 
3,300,000 
1,500,000 
3,300,000 
3
3,000,000
3,300,000
4
9,000,000
3,300,000
Total Inflows
14,500,000
13,200,000
Net Inflows
4,5000
3,200,000

DISCOUNTED CASH FLOWS

Calculating NPV at desired rate

For calculation of NPV, there are a number of steps to be taken as given below:

  1. Workout Operating Cash flow which, in simple terms, is adding back depreciation and markup in the net profit.
  2. Place total investments in year 0 which marks end of the construction year.
  3. Show year-wise income against respective years.
  4. Like in 3, write down discount rate applicable to each year at the desired discount rate which in our example is 12%.
  5. Findout discounted values and added them up. This would be Present Value.
  6. Deduct from this investment in year 0 and you will find NPV.

Necessary calculations are given in the side table. The weaving project would be rejected as NPV <1. The oil plant would be accepted as NPV >1.

Tools for taking Capital Decisions

Capital expenditure decisions are becoming frequent rather than rare. This hub examines ways and means to assess soundness or wisdom of such decisions through testing them with various tools which are both financial and non-financial.

The eventual aim could be sustainability or expansion which ever is the need of the time. For sustainability, one makes up the shortfalls in the plant or merely replaces the old equipment or modernizes the plant through installing better technology.

 

Some clarifications

DETERMINATION OF DISCOUNT RATES

Choice of discount rate depends upon a number of factors. Generally, Cost of funds (Average Weighted Cost of Capital - AWCC) is used. If NPV= AWCC, at least we have covered our cost which includes dividends to share holders.

Other bench marks are : opportunity cost, group hurdle rates or a rate advised by planning commission of a country.

INDEPENDENT OR MUTUALLY EXCLUSIVE PROJECTS

Some times, an investors has restricted funds enough for one project. In this case, all eligible projects would be ranked and one with the highest NPV or IRR would be chosen. If the same investor has unlimited funds, all projects meeting criteria would be selected.

So mutually exclusive projects are those where acceptance of one eliminates consideration of others. While independent projects have no such conditions.

WEIGHTED AVERAGE COST OF CAPITAL

Funds from a project come from a variety of sources such as Shareholders contribution, loans from local and foreign banks.  Except share-holder funds, there are tax consideration for others. The amount obtained would be weight assigned while rate would be after tax rate. Taking these two factors into consideration, we arrive at a WACC.

CONCLUSION

In Capital Expenditure Decisions, a long term view is taken into consideration. While investment would be made now, the revenue would accrue in future. Since a rupee now is better than a rupee in the next year, we use discounted techniques to find out present value of future cash flows.

At times, payback period is a strong stimulus for taking a decision for capital expenditure. When environments are uncertain or there is a law and order situation, an investor would attach more weight to payback period rather than IRR or NPV.

For development banks or governmental organization, economic factors are considered such as forex earning, regional development and alleviation of poverty..

Comments

    0 of 8192 characters used
    Post Comment

    • profile image

      Theary 3 years ago

      Thank for spread it

    • hafeezrm profile image
      Author

      hafeezrm 6 years ago from Pakistan

      Thanks Steve.

    • profile image

      Steve 6 years ago

      Well researched,perfecto!!

    • profile image

      Jitendra Kumar Sharma 7 years ago

      this is fantastic details for finance students...this helps me a lot...........thanks

    • profile image

      Accounting firm 8 years ago

      More good informations thanks for helping me out. Always a pleasure to see information that is useful, thanks again

      http://www.kpmgaccountingfirm.info

    • hafeezrm profile image
      Author

      hafeezrm 8 years ago from Pakistan

      Thanks for your comments.

      OPEX / RAVEX has been covered in a previous hub https://hubpages.com/education/Project-Management-...

    • Rufi Shahzada profile image

      Rufi Shahzada 8 years ago from Karachi

      Dear Sir,

      Being a student of FINANCE your HUBS are helping me a lot, In fact you have provided me a CHANNEL OF CONSTANT LEARNING. Though, I have studied CAPEX earlier in depth but you have made it so simple. I am looking forward to learn RAVEX and OPEX from your Hubs....

      A Million Thanks!

      RUFI SHAHZADA

    • creativeone59 profile image

      benny Faye Douglass 8 years ago from Gold Canyon, Arizona

      Thank you for a great hub on financial management. Thanks for sharing. creativeone59

    working

    This website uses cookies

    As a user in the EEA, your approval is needed on a few things. To provide a better website experience, hubpages.com uses cookies (and other similar technologies) and may collect, process, and share personal data. Please choose which areas of our service you consent to our doing so.

    For more information on managing or withdrawing consents and how we handle data, visit our Privacy Policy at: "https://hubpages.com/privacy-policy#gdpr"

    Show Details
    Necessary
    HubPages Device IDThis is used to identify particular browsers or devices when the access the service, and is used for security reasons.
    LoginThis is necessary to sign in to the HubPages Service.
    Google RecaptchaThis is used to prevent bots and spam. (Privacy Policy)
    AkismetThis is used to detect comment spam. (Privacy Policy)
    HubPages Google AnalyticsThis is used to provide data on traffic to our website, all personally identifyable data is anonymized. (Privacy Policy)
    HubPages Traffic PixelThis is used to collect data on traffic to articles and other pages on our site. Unless you are signed in to a HubPages account, all personally identifiable information is anonymized.
    Amazon Web ServicesThis is used to collect data on traffic to articles and other pages on our site. Unless you are signed in to a HubPages account, all personally identifiable information is anonymized. (Privacy Policy)
    CloudflareThis is used to quickly and efficiently deliver files such as javascript, cascading style sheets, images, and videos. (Privacy Policy)
    Google Hosted LibrariesJavascript software libraries such as jQuery are loaded at endpoints on the googleapis.com or gstatic.com domains, for performance and efficiency reasons. (Privacy Policy)
    Facebook LoginYou can use this to streamline signing up for, or signing in to your Hubpages account. No data is shared with Facebook unless you engage with this feature. (Privacy Policy)
    PaypalThis is used for a registered author who enrolls in the HubPages Earnings program and requests to be paid via PayPal. No data is shared with Paypal unless you engage with this feature. (Privacy Policy)
    Google AdSense Host APIThis service allows you to sign up for or associate a Google AdSense account with HubPages, so that you can earn money from ads on your articles. No data is shared unless you engage with this feature. (Privacy Policy)
    Features
    Google Custom SearchThis is feature allows you to search the site. (Privacy Policy)
    Google MapsSome articles have Google Maps embedded in them. (Privacy Policy)
    Google ChartsThis is used to display charts and graphs on articles and the author center. (Privacy Policy)
    Google YouTubeSome articles have YouTube videos embedded in them. (Privacy Policy)
    VimeoSome articles have Vimeo videos embedded in them. (Privacy Policy)
    MavenThis supports the Maven widget and search functionality. (Privacy Policy)
    Marketing
    Google AdSenseThis is an ad network. (Privacy Policy)
    Google DoubleClickGoogle provides ad serving technology and runs an ad network. (Privacy Policy)
    Index ExchangeThis is an ad network. (Privacy Policy)
    SovrnThis is an ad network. (Privacy Policy)
    Facebook AdsThis is an ad network. (Privacy Policy)
    Amazon Unified Ad MarketplaceThis is an ad network. (Privacy Policy)
    AppNexusThis is an ad network. (Privacy Policy)
    OpenxThis is an ad network. (Privacy Policy)
    Rubicon ProjectThis is an ad network. (Privacy Policy)
    TripleLiftThis is an ad network. (Privacy Policy)
    Say MediaWe partner with Say Media to deliver ad campaigns on our sites. (Privacy Policy)
    Remarketing PixelsWe may use remarketing pixels from advertising networks such as Google AdWords, Bing Ads, and Facebook in order to advertise the HubPages Service to people that have visited our sites.
    Conversion Tracking PixelsWe may use conversion tracking pixels from advertising networks such as Google AdWords, Bing Ads, and Facebook in order to identify when an advertisements has successfully resulted in the desired action, such as signing up for the HubPages Service or publishing an article on the HubPages Service.
    Statistics
    Author Google AnalyticsThis is used to provide traffic data and reports to the authors of articles on the HubPages Service. (Privacy Policy)
    ComscoreComScore is a media measurement and analytics company providing marketing data and analytics to enterprises, media and advertising agencies, and publishers. Non-consent will result in ComScore only processing obfuscated personal data. (Privacy Policy)
    Amazon Tracking PixelSome articles display amazon products as part of the Amazon Affiliate program, this pixel provides traffic statistics for those products (Privacy Policy)