Chapter 16 Notes
- Recognize the reason that a capital budget expenditure budget is necessary
- Review the cash flow and the startup cost concept
- Understand differences between cash flow reporting methods
- Recognize types of capital expenditure budget proposals
- Understand about evaluating capital expenditure proposals
Capital expenditures involve the acquisition of assets that are long lasting, such as equipment, buildings and land. Capital expenditure budgets are usually intended to plan, monitor and control long term financial issues. Capital budgets are usually for extended periods of time. Usually three, five or ten years. Capital budget is usually the responsibility of upper level management.
Creating the Capital Expenditure Budget
Consists of two parts. The first part represents spending for capital assets that have already been acquired and put in place. This part protects existing assets. You’re actually spending to protect that which you already have.
The second part of the budget represents spending for new assets.
The “existing asset” part of the budget forces planning questions about whether existing equipment and buildings should be kept in their present condition, renovated or replaced.
The new asset part forces more planning questions. The reasons for new asset spending may involve:
- Expansion of capacity in a department or program.
- Creation of a new facility, department or program.
- New equipment to improve productivity.
- New equipment or space to comply with federal or state requirements.
Budget Construction Tools
Usually the construction of a capital budget is determined by the organizations requirements. There may be a template that the manager must follow. If not, the manager must select the tool that best works for their needs.
One important tool is net cash flow reporting. Cash Flow Concept is when cash flow analysis illustrates how the project’s cash will flow over a period of time. Analysis is usually concentrated on cash expenditure, but cash receipt must also be considered. When the replacement of old equipment generates cash from the sale, we would look at net cash flow.
The Cash Flow Reporting Methods are:
- Payback Method – recognizes the cash flows that are necessary to recover the initial cash investment
- Accounting Rate of Return – based on profitability, does not take time value of money into account
- Net Present Value – discounted cash flow method based on cash flows in that it takes all the cash into account over the life of the equipment, takes profitability and time value of money into account
- Internal Rate of Return – also discounted cash flow, similar to NPV
These methods were discussed in detail in Chapter 12.
Capital Expenditure budget inputs may have to be taken into account if the operating budget requires additional capital equipment or space renovations. See Figure 16 – 1.
Startup Cash Concept
If the proposal for capital expenditures incorporates operational expenses, management believes the cost of starting up a new service line or program should be included as part of the original investment.
Discusses the process of requesting capital expenditure funds and the types of proposals.
The Process of Requesting Capital Expenditure Funds
Due to reduced funding sources, departments often must compete with one another for the available capital funds. The various request for funding are collected from all departments and subjected to a review by upper management in order to make decisions about where, and to whom, the available capital expenditure funds will go.
Types of Capital Expenditure Proposals
The type of proposal affects its size and scope. Proposal types are as follows:
- Acquiring new equipment – reason new equipment is needed, acquisition cost must be reasonable, number of years of useful life must be known
- Upgrading existing equipment – reason upgrade is necessary, impact of upgrade, outcome of upgrades, costs must be reasonable, will upgrade extend the life.
- Replacing existing equipment with new equipment – rationale for replacing existing equipment, comparison between replacing and new equipment, will new equipment increase productivity/outcomes
- Funding new programs – take startup costs into account, more extensive proposal because it involves new program without prior history
- Funding expansion of existing programs – utilize statistics from previous program, startup costs should be negligible
- Acquiring capital assets for future use – most difficult to accomplish. Proposals usually postponed due to lack of cash.
Evaluating Capital Expenditure Proposals
Due to the lack of available resources, organizations must ration the available capital funds. Most organizations will consider the following factors in making their decisions:
- Necessity of the request
- Cost of Capital to the organization
- Return that can realized on alternative investments