Friday 10 December 2021

What to Include in Project capital expenditure?

Capital expenditure budget is the budget of the relevant principles and methods for enterprises to select and evaluate long-term capital investment activities (e.g. purchase, construction and expansion of fixed assets) in the future period. 


When an investment is made, cash expenditures are returned to cash inflows for future periods. and investment plans need to be judged on their returns: 


Does a particular investment meet the needs of investors? 

Are the possible cash inflows and expenditures comparable to investment criteria met? 

Is the outcome of an investment beneficial to the company's share price? 

What is the relationship between the risk and return of an investment? 

These are the main core issues that should be considered in capital expenditure budgets.

Successful capital investment action plans are divided into the following steps: 


First, the generation of investment intentions and proposals, followed by the estimation of strategic, market and technical factors, projected cash flows, then the evaluation of cash flows, the selection of projects on the basis of acceptable criteria, and finally the implementation of the plan and the continuous re-evaluation and ex post audit of the cash flows and economic conditions of investment projects after acceptance.

The role of capital expenditure budget

Because capital expenditure is generally involved in relatively large investment projects or a large number of fixed assets purchase, the current financial situation of enterprises and future period of operating income have a relatively large impact, while there is a great deal of risk, so the capital expenditure budget is prepared in order to these projects can be carried out in advance, in the event, after the evaluation and control, as far as possible to achieve "precaution before they happen".

To be prepared, we should clarify two basic financial concepts when investing in capital: the value of monetary time and the value of risk compensation.

(1) monetary time value: 


The so-called value of money time refers to the value added by the investment and reinvestment of money over a period of time, without taking into account inflation and risk. according to western economists, investors must delay spending, and investors should be rewarded for their patience to delay spending, which should be proportional to the length of time they are delayed, so the percentage of the amount of money that is paid per unit of time (usually yearly) is the value of money and time.

the essence of monetary time value is the value appreciation, and it is the value added in the cycle turnover process after the currency is put into use. the longer the investment time, the more times the cycle turnover, the greater the value added, and the greater the time value of money.

(2) risk compensation value: 


Risk compensation is the part of the investor's compensation that exceeds the value of time by taking risks to invest. it has two representations: risk compensation and risk reward rate. in management decision-making, in order to compare the advantages and disadvantages of different capital expenditure items, the relative number-risk rate of return is generally used to measure.

Investment risk is objective. financial decisions are made almost exclusively in the face of risk and uncertainty. without risk, it is impossible to evaluate the level of corporate compensation correctly. there are many risks of enterprises, from the point of view of individual investment subjects, enterprise risks mainly have market risks (refers to those that affect all factors affecting the company such as war, economic recession, inflation, natural disasters and other force majeure), business risks (refers to the risks brought about by the uncertainty of production and operation, it is any business activities will exist also known as commercial risks. 


It mainly comes from four aspects: market sales, such as market demand, price uncertainty, production costs, such as supply delays and price increases of direct materials, wage costs and productivity decline, production technology, such as product quality accidents, new technologies, other factors such as industry downturn, vicious competition, etc., and financial risk.

Financial risk refers to the increased risk due to borrowing, is the risk brought about by financing decision-making, also known as financing risk. 


There are three famous theories of financial risk: mm theory, trade-off theory and information asymmetry theory. mm theory abstracts the risk of corporate financing, and holds that in the case of corporate income tax restrictions, because the interest expense of the liability can be paid before income tax is paid, so the debt has a tax reduction effect, the more the enterprise uses the debt to raise funds, the better. 


The trade-off theory considers the benefits of liabilities, but also considers the risks of debt financing, and holds that when enterprises have liabilities, they may be unable to pay due, thus creating the cost of financial crisis and increasing financial risks. the theory of information asymmetry holds that the information that the investors of the enterprise management personnel have about the business conditions of the enterprise is not equal, and the managers can get more valuable internal signals about the investment risk of the enterprise's future earnings. debt financing represents a good future development prospects of enterprises, financial risk is small, equity financing represents the future development of enterprises do not have confidence, increased risk.

The preparation of capital expenditure budget

Since one of the most important aspects of the capital expenditure budget is to express the economics and technicality of a project in terms of projected future cash flows. after quantifying the technical indicators, the comparison of the advantages and disadvantages can be made, and then the corresponding decisions can be made, and then the investment return of capital expenditure can be prepared for the selected investment projects accordingly.

Companies are now investing cash capital in order to get a bigger amount of cash returns in the future. image metaphorically cash is the blood of the enterprise, and capital investment projects are the heart of the enterprise. 


The successful projects become the driving force for the smooth flow of cash in the enterprise, reducing the supply of funds for good new projects is equivalent to aging the heart of the enterprise, so it is very important to put forward reasonable capital projects and objective evaluation, then it is necessary to use the investment decision budget indicator system to complete the task from time to time.

The main key assessment indicators of capital expenditure budget are the following two categories: non-discounted cash flow indicators and discounted cash flow indicators.

Non-discounted cash flow indicators are those that do not take into account the value of time and regard money balances and expenditures at different times as equivalent. 

These indicators are: 


The return on investment (PP)- the amount of time it takes for cash inflows from an investment to accrue to the same amount as the amount invested, i.e. the time required to recover the initial investment, which is primarily used to measure the liquidity of the investment plan rather than profitability. 


Average Return on Investment (ARR)- Refers to the average annual return on investment over the life of an investment project, i.e. equal to the average annual cash flow/total original investment, which does not take into account the impact of time value and ignores risk factors and treats cash flows in future years as the same value as current years, which can lead to incorrect decisions.

Discounted cash flow indicators are those that take into account the time value of funds, and the main indicators are: 

Net Present Value (NPV)- 


Net cash flow after an investment project is put into use, converted to present value at the cost of capital or the rate of return required by the enterprise and less the balance after the initial investment. 


The Act takes into account the time value of money, but the use of the Act requires enterprises to determine a discount rate in advance, subjective tendency to reveal the programme itself of what the compensation ratio is, in addition, NPV method is an absolute comparison of the NPV of two or more schemes, without taking into account the initial investment size, the length of the payback period and other factors, can not truly reflect the profitability of the scheme. Present Value Index (PI)- 


The ratio of the total present value of future compensation for an investment project to the present value of the initial investment. The indicator takes into account the time value of money, and is a relative number, overcomes some of the disadvantages of NPV, objectivity is good for comparison between different schemes of initial investment. 


But there is also the suspicion of subjective discount rate and the confusion of economic meaning is difficult to understand. Internal Rate of Return (IRR)- A discount rate where the NPV of an investment project is equal to zero, which actually reflects the true remuneration of the investment project. 


The indicator takes into account the value of monetary time and can reveal the true compensation ratio of each scheme itself, but the calculation process is more complicated.

No comments:

Post a Comment