Capital Budgeting

Management is originally hired to take control of the funds of the owners of the business. In most cases, it involves the maximization of the earning power of these funds. The planning and control of capital expenditures is, therefore, a basic executive function. As such, the budgeting of funds for capital expenditures is a very important activity of management.

In this chapter, capital budgeting as an important segment of business finance is presented. Among those included are the relevant concepts pertaining to investment, valuation, risk, and uncertainty.

BASIC TERMS IN CAPITAL BUDGETING

For a better understanding of capital budgeting concepts, the following terms are defined and explained: capital expenditures, capital budgeting, valuation, and investments.

Capital Expenditure

The term capital expenditure refers to substantial outlay of funds the purpose of which is to lower costs and increase net income for several years in the future. It includes expenditures that tie up capital inflexibility or long periods. It covers not only outlay for fixed assets but also expenditures for major research on new products and methods and for advertising that has cumulative effects.

Classes of Capital Expenditure. Capital expenditures may be classified into the following:

1. Replacement Investments – this refers to investments on replacement of worn-out or obsolete facilities;

2. Expansion Investments – this type of expenditure will provide additional facilities to increase the production and/ or distribution capabilities of the firm;

3. Product-line or New Market Investments – this refers to expenditures on new products or new markets, and on improvement of old products with the combined features of replacement and expansion investments.

4. Investments in safety and/or environmental projects – these are expenditures necessary to comply with government orders, labor agreements, or insurance policy terms. These are sometimes called...