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• Evaluation and justification
• Proposed timelines
• Potential savings and benefits of the purchase
DIMENSIONS AND CHART OF ACCOUNT CONSIDERATIONS
For capital expenditures, one useful piece of information is whether the expenditure was for growth or replacement purposes. This will enable the company to determine how much will be spent to grow the company and how much to maintain current processes. In order to eliminate extra dimensions, you can use line-item detail to bud- get for each account type. For chart of accounts, you will typically have different account numbers for each capital expenditure type, such as furniture, buildings, or software.
TOP-DOWN OR BOTTOM-UP APPROACH
Deciding how to allocate money for each capital expenditure can be a difficult process at companies where there is a limited amount of money and many proposals. In a strictly top-down approach, though the executives will declare who will get how much, the departments will still fight for each dollar. In a strictly bottom-up approach, managers will turn in the budgets, but their amounts may be greatly reduced when the available cash is realized. Thus, a hybrid method is best for capital budgeting. Ex- ecutives will determine a budgeted amount for total expenditures, then determine an interim plan of where the money will be allocated prior to the budgeting process. The managers should have a good idea of which items they will need in the next year to improve their departments.
Managers should receive some direction from the executives before they start their budgets. Thereafter, the executives review the expenditures listed by manage- ment; they analyze and approve (or reject) expenditures based on their knowledge and experience. Ideally, the managers are told how the approval process works so that they can attach any supporting documents or analysis to their budgets before the ex- ecutives make their final decisions.
DRIVERS
The drivers of capital budgeting are, simply, the various categories of capital budgeting:
• New machines and equipment. Companies will buy new equipment in order to expand business operations.
• Replacement machines. These purchases are made to replace outdated machines or to increase efficiency. In the latter case, there may be revenue associated with the sale of the old machines.
• Mandatory projects. This expenditure is usually related to government regula- tions, such as the requirement to install a wheelchair ramp for handicapped con- sumers, or to implement new procedures to get rid of hazardous materials.
• Other capital expenditures. These consist of various other long-term investments, such as purchasing patent rights, acquiring land, or expanding office space.
ASSUMPTIONS
For managers, there are two main assumptions in capital budgeting. The first is the cost of the purchase, and this is usually a cost at “time zero”; in other words, the cash is paid by the company immediately, not over time. One concern for a company is whether a manager will have the necessary knowledge to make this determination.
In terms of machinery or software that will be used by the manager’s department, then it would be a fair assumption that the manager has a reasonable idea of the cost.
But a manager probably would not know how much it would cost to buy land or to make an improvement to the building. These types of expenditures should, therefore, be determined by those who do know, which will usually be upper management.
The other main assumption is the life of the purchase. If you are only doing a one- year budget, and you do not budget your balance sheet, then this is not very impor- tant. However, the life of the product will affect your balance sheet and cash flow in terms of plant, property, equipment, and depreciation for your income statement.
Many companies will set a number of years for life based on the account number. For example, a software purchase may have a life of 3 years, and a new building may have a life of 35 years. This decision should be made by top-level management.
SPECIAL CONSIDERATIONS
Business conditions, government regulations, and the economy all can have an impact on capital purchases, many of which are difficult to determine in the budget year. It is very difficult, if not impossible, to forecast for unplanned capital expenditures. There- fore, companies usually set aside a certain amount of capital to spend and conserve a certain amount for these unplanned expenditures, such as a machine that breaks down.
Many terms and calculations are used by analysts to determine which capital expenditures to choose:
• Initial costs. These are simply the costs of starting a project or of purchasing an expensive item, such as a building. The total is the amount that will be amortized over the life of the project.
• Incremental cash flow. This is the difference between the cash flow prior to the project and after the project has been completed, if all else in the organization remains the same. It is important to know how much a project will increase or decrease the cash flow in an organization.
• The following is a list of capital budgeting techniques used to determine the rate of return of the capital expenditures:
• Average rate of return. This is used to determine the profitability of a project.
It may be the oldest and simplest technique used in business. The formula takes the average annual future net earnings from the project divided by one- half of the initial investment. The main pitfall of this technique is that the av- erage rate of return ignores the time value of money. The time value of money
determines the present value of cash over a period of time. In other words, a dollar tomorrow is worth less than a dollar today.
• Payback period. This is the number of years needed to recover the initial in- vestment. It is up to the company to determine what is an acceptable length of time for the project. The two drawbacks to this type of analysis is that it does not include the time value of money and it ignores the profitability of the pro- ject. Basically, this method only calculates how long it will take to get money back; it ignores any revenue/savings earned after that date.
• Net present value. This calculates whether the present value of cash flow is greater or less than the initial cost of the project. Simply, if the net present value is greater, then the project will be accepted. The advantages of net pres- ent value are that it uses cash flow in the calculation, it recognizes time value of money, and the company will increase value if it accepts projects with positive net present values. Its drawbacks are that it is based on the forecast of the future cash flows and the discount rate that is used, and it is not simple to calculate.
• Profitability index. This index is calculated by taking the present value of fu- ture cash flows divided by the initial investment. If the index is greater than 1, then the project will be accepted. This is comparable to the net present value and has the same benefits and drawbacks.
• Internal rate of return. This is a measure of the rate of profitability. By defin- ition, the internal rate of return is the discount rate that makes the present value of cash flows equal to the initial investment. Each company will determine its own cutoff rate, which is the required rate of return per project. The cutoff rate is determined by the cost of financing for the company and the risk level of the project. This has the same advantages of the net present value, but it is easier to calculate. The main drawback is that it often gives unrealistic rates of return.
USERS
For the users, the form should be fairly simple, because the managers will typically keep additional information in another type of format. The form should have input lines for each type of capital expenditure, for example, software or buildings. On each of these lines, the user should be able to input the following: a comment regarding the purchase, a total cost, the life of the product, and the month of the purchase. The life of the product may have been set by upper management, but if not, there should be a limitation on the number of years to select. The form will then automatically calculate the depreciation for the income statement, and the cost of the product will be stored for the balance sheet.
BEST PRACTICES
For managers, capital budgeting should notserve as a lesson in finance; therefore, the budget should be separated into large and small capital expenditures. The large expenditures should first be prepared and approved by the corporate finance depart-
ment, then approved by the executives. In short, these expenditures should not be part of the budget until they have been approved. Furthermore, these expenditures should be prepared in much greater detail because they will come under greater scrutiny. And the finance department should inform managers of the maximum amount they can budget for each expenditure.
The budget form should be kept as simple as possible for the managers. It should be divided according to the different types of expenditures. The two entries will be cost and purchase month. The life of a capital expenditure should be determined prior to the budget by the finance department. Each type of account should be assigned a lifespan. Software may be given a life of 3 years, for example, while a building may be given a life of 35 years.
The budget software form should then automatically calculate the depreciation for the duration of the budget; hence, if you are budgeting for one year (generally), then the depreciation will be calculated by straight-line depreciation for the entire year. The cost of the expenditure will then be added to the plant, property, and equip- ment in the balance sheet (see Exhibit 13.1).
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CAPITAL EXPENDITURES—SAMPLE BUSINESS UNIT 001 Currency: USD FurniturePurchaseLife DescriptionMonthCost(Years)JanFebMarAprMayJunJulAugSepOctNovDec Cubicle Furniture325,000500417417417417417417417417417417 Office Furniture447,5005000792792792792792792792792792 Training Desks812,50050000000208208208208208 Total Furniture Description004171,2081,2081,2081,2081,4171,4171,4171,4171,417 EquipmentPurchaseLife DescriptionMonthCost(Years)JanFebMarAprMayJunJulAugSepOctNovDec Tractor1250,00072,9762,9762,9762,9762,9762,9762,9762,9762,9762,9762,9762,976 Garbage Truck4175,00070002,0832,0832,0832,0832,0832,0832,0832,0832,083 Total Equipment Depreciation2,9762,9762,9765,0605,0605,0605,0605,0605,0605,0605,0605,060
125 Capitalized SoftwarePurchaseLife DescriptionMonthCost(Years)JanFebMarAprMayJunJulAugSepOctNovDec Budgeting Software2125,000303,4723,4723,4723,4723,4723,4723,4723,4723,4723,4723,472 Asset Management495,00030002,6392,6392,6392,6392,6392,6392,6392,6392,639 Total Capitalized Software Depreciation03,4723,4726,1116,1116,1116,1116,1116,1116,1116,1116,111 Total Description2,9766,4486,86512,37912,37912,37912,37912,58712,58712,58712,58712,587 EXHIBIT 13.1Capital Expenditures Example
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