Capital Expenditure Decisions

Capital Expenditure Decisions Capital expenditures are disbursements that provide benefits extending over a long period of time. Examples of capital expenditures include the purchase of a computer, a printer, or a truck. Capital expenditures are initially recorded as assets and are allocated proportionately to expense over the time period they provide benefits to the company. The decision to record a disbursement as an asset or an expense is usually determined by the expected period of benefit. Disbursements expected to benefit the company for more than one year are recorded as capital expenditures. Disbursements expected to benefit the company for less than a year are termed revenue expenditures and are recorded as expenses. The Capital Budgeting Process The capital expenditure decision process is termed capital budgeting. In a very small business the capital budgeting process is rather informal. The owner perceives a need for an item such as a truck. Decisions are made as to the type of truck needed and the resources available, and a suitable truck is purchased. The truck is then used by the business, and its cost is depreciated over its useful life as discussed in Chapter before As the size of the organization increases, the need for a formalized capital budgeting process also increases. For example, assume that an organization has three divisions, each of which has a manager with a "pet project" that he or she believes is important to the organization. Resources are not available to pay for all three projects, and only one project one be undertaken during the current year. Which one should be chosen? The capital budgeting process must be designed to solve problems of this type. Evaluating capital budgeting proposals is a long and involved pro-cedure. The company must evaluate investment opportunities as well as available resources. The evaluation of capital budgeting proposals is termed the capital budgeting cycle. A typical capital budgeting cycle begins with the detection of needs and the submission of formal requests for capital expenditures. These requests are evaluated by determining the economic viability of each request and the overall needs of the organization. Projects that lack economic merit or that do not contribute to the overall goals of the organization are eliminated. A final screening of feasible projects is made based on the overall resources available, and the chosen projects are implemented. Subsequently, follow-up procedures are used to review the costs and benefits of the completed projects to aid in future decision making. The cycle begins again as other needs are detected. Most of the material in this chapter focuses on the screening and evaluation segment of the capital budgeting cycle. The screening and evaluation process is used to determine which projects are economically viable. If a number of projects are viable but sufficient resources are not available to undertake all of them, the screening and evaluation process should also be capable of ranking the projects, that is, determining the most favorable project, the second most favorable, and so forth. The follow-up procedures mentioned above must also be an integral part of the capital budgeting process. A follow-up evaluation of a project is often referred to as a postaudit. The purpose of the postaudit is to determine whether or not the expected results from the project were actually realized. The procedures employed in the postaudit process are essentially the same as those used in the screening and evaluation process except that actual results are used instead of the estimated anticipated results. Postaudit procedures enable management to learn from both successes and failures. The following are the types of questions that a capital budgeting process is frequently called on to answer. Should a new plant or equipment be purchased in order to increase capacity or reduce costs? Several possible types of equipment are available; which should be selected? Should new equipment be leased or purchased? Should old equipment be replaced now or later? The concepts discussed in the remainder of this chapter provide a basis for evaluating the economic feasibility of projects. Individuals with accounting training are frequently called on to make these eval-uations. Project evaluation work is interesting but demanding. It demands a high degree of attention to detail and mathematical and financial sophistication.