DOWNLOAD PDF ANALYZING CAPITAL EXPENDITURES

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1 Chapter 1 : Capital Expenditure (Capex) - Guide, Examples of Capital Investment The first step in a capital expenditure analysis is a factual evaluation of the current situation. It can be a simple presentation of quantitative data or a more detailed evaluation that also. One of the drawbacks of non-discounted techniques for evaluating investment criteria is the ignorance of timing of cash inflows and outflows. Another drawback of traditional techniques is that entire cash proceeds are not taken into consideration for analysis. Therefore, improper matching of cash inflows and outflows gives misleading results. Thus discounted payback period, Net present value. Modified internal rate of return, and Profitability index have been developed to overcome the problems associated with traditional techniques. This method has been developed to overcome the limitations of non-discounted payback period. Instead of normal cash inflows, discounted cash inflows are employed to calculate the payback period. It is the time required to recover the initial cost of investment through discounted inflows of a project. The advantages of discounted payback period are: The disadvantages of discounted payback period are: From the following information, compute the discounted payback period of the project. This is another method for evaluating the capital expenditure decision using the discounted cash flow method. Under this method a stipulated rate of interest, usually the cost of capital, is used to discount the cash inflows. The Net Present Value NPV is calculated by taking a difference between the sum of present value of cash inflows and sum of present value of cash outflows. Symbolically, NPV of a project can be calculated as follows: The following rules should be adopted for accepting or rejecting a project under NPV: The advantages of NPV are: The NPV method also suffers from certain limitations. These are; a In comparison to traditional method, it is slight difficult to understand and calculate. The initial investment required for a project is Rs 2, 00, having life of 3 years. The expected cash inflows from the project are Rs 1, 10,, Rs 1, 60, and Rs 30, for 1st, 2nd and 3rd year respectively. Internal Rate of Return: Unlike the NPV method a stipulated rate of interest is avoided. This method is also known as Yield on investment. Marginal efficiency of capital and Marginal productivity of capital. The internal rate of return is that rate of discount which equates the present value of expected cash inflows from a project with present value of cash outflow. In other words, internal rate of return is that rate of discount which makes the net present value of a project equal to zero. The following rules should be adopted for accepting or rejecting a project under IRR method: The advantages of IRR are summarized below: The IRR suffers-from the following disadvantages: While computing IRR the following situations may arise: Equal Series Future Cash Inflows: When the future cash inflows from a project are equal the following steps may be followed for computing the IRR Step I: Divide the initial cash outflow by annual cash inflow, i. Search the nearest discount factor considering the life of the project. The rate of interest corresponding to the discount factor gives you the internal rate of return. A project requires an initial investment of Rs 40, The annual cash inflows are estimated at Rs 13, for 4 years. Calculate the internal rate of return. Unequal Series of Future Cash Inflows: A project requires Rs 11, and the cash inflow from the project is as follows: Calculate the IRR of a project which initially cost Rs 2, and generates cash flows of Rs and Rs 1, during 1st and 2nd year of its life. Modified Internal Rate of Return: Firstly, IRR assumes that positive cash inflows from a project are reinvested at the same rate of return as that of the project. This is an unrealistic assumption because it will be reinvested at the rate closer to cost of capital. Secondly, more than one IRR can be found if a project has alternative positive and negative cash inflows, which leads to confusion. However, MIRR gives only one rate. Under MIRR all cash inflows are brought to terminal value using a specific discount rate, generally the cost of capital. MIRR is that rate which equates the terminal value of cash inflows with the compounded value of cash outflows. MIRR offers the following advantages: Although this method is better than IRR, it suffers from certain disadvantages, which are: An investment of Rs 68, yields the following cash inflows after tax: Profitability index or benefit cost ratio is the ratio of present values of future inflows and outflows of a project. It is a relative measure of an investment decision. It can be calculated by using the following formula: The following are the advantages of PI: Profitability index suffers from the following disadvantages: A project requires an initial investment of Rs 5, 00, The estimated life of the project is 5 years and expected to generate Rs 1, 00,, Page 1

2 Rs 1, 50,, Rs 1, 80,, Rs 2, 50, and Rs 75, respectively from 1st year to 5th year. Page 2

3 Chapter 2 : How should a company budget for capital expenditures? Investopedia Analyzing the pros and cons on a capital expenditure for production involves understanding the current production capacity with its cycle times and gross profit, and determining what the increase in production capacity will be from purchasing the equipment. Present value of a net cash flow of a year is found by discounting the cash flow with the cost of capital. Internal Rate of Return IRR In internal rate of return calculation, the concept of net present value is used but with a difference. To determine IRR present value of cash inflows is equated to the present value of cash outflows with cost of capital taken as the unknown variable. When this equation is solved, you get a rate of return at which NPV is equal to zero. IRR is then compared with cost of capital by the finance department. A department may submit a project with Cost of capital keeps changing depending on the interest rates and risk premium in financial markets. Benefit Cost Ratio Benefit cost ratio is the ratio between present value of cash inflows and present value of cash outflows. Payback Period It is a simple measure. It is the length of the time required to recover the initial cash outlay on the project through net cash inflows. Let us assume the project has an initial cash outlay of Rs. The net cash inflows at the end of each during the first five years be: In first three years, the project will give back cash inflow of Rs. Hence for this project, payback period is 3 years. Accounting Rate of Return In this method, profits are projected by the project accounting statements method instead of cash flows. The average of profit after tax say for first fives years is divided by the average book value of fixed assets five years committed to the project. This is not a rigorous measure. Firms use multiple methods Accounting rate of return and pay back period are still used by many. Risk assessment of the projects is done and cost of capital is adjusted for risk. Risk assessment is done by sensitivity analysis. Each unit is responsible for maintaining the accuracy of this document over time. Every unit is encouraged to take a long-term strategic approach to providing its services. This approach entails an annual review of the costs that must be incurred to provide valued services regardless of past practices at the most efficient and understandable cost. Once this level of service and funding is established, increments to the baseline are considered. Ideally this would involve the following approach: Defining the current and future level of services provided, the resources necessary to provide those services and rationale for major change. Evaluate current operations and identify issues and the gaps to providing future levels of service. Look internally for cost saving measures or the elimination of services that are no longer required. It is assumed that before any funding request comes forward that it has the approval of the Associate Vice President or Executive Director responsible for that unit. Look cross-organizationally for resource allocations and efficiencies. Budgeting Policy and Terminology Budgeting and planning are done on two distinct platforms: The Operating budget is a financial plan of current operations that encompasses both estimated revenues and expenditures for a specific period, normally a fiscal year. Critical components of the Operating Business Plan are defined below: A Baseline budget is defined as the steady state operating position of each unit. This reflects the resources required for a unit to provide the same level of service in the current year, before any new priorities or funding requests. Specifically included are full year salary, benefits, and other normal operating expenses, including an allocation for capital expenses. Salary expenses in the baseline include open positions for the year positions that have been open for one year should not be included. Re-occurring overtime and other non base compensation costs are included. The Final budget includes the baseline budget as well as any onetime modifications to the current year operating plan. These onetime adjustments may be additions or deductions from the revenues and expenses of the unit. The final budget reflects how we expect actual results to look at the conclusion of the budget period. Forecast actual revenue and expenditures: The forecast is based on actual revenues and expenses and therefore excludes open positions and encumbrances. New Priorities pertain to any material change in service level from the current business activity. This change can be an increase or a decrease in service, and does not necessarily have funding implications. Major increases in costs to continue the current levels of service are technically not new priorities, but for the sake of simplicity should be brought forward in this category if they are significant. The Capital Budget outlines expenditures for major equipment, Page 3

4 software including upgrades, repairs, renovations, and construction. Capital Budgets should be separated from operations by being accounted for in the Plant Fund. Capital Budgets require the following components: Amount of anticipated actual expenditure. Year of intended expenditure. Useful life of the asset. Capital Plans should include a minimum of 10 years for capital intensive units and 5 years for units with small equipment needs. A unit that is not supported by recharges may transfer balances to departmental equipment fund with the only restriction being that it is used for items that are capital in nature. Page 4

5 Chapter 3 : Capital Expenditures Definition and Explanation Capital expenditure analysis is the means by which we determine the value- creation potential of a project. Correctly determining this potential is critical to the successful. You should do better. My query is how do we come to a value on Capex? Not precise but on a rough basis? I suggest that you look at an average of the past 5 years of capital expenditures versus asset growth and calculate average maintenance capex. Maintenance capex MCX is mandatory while growth capex is not. See previous post on growth vs. But most importantly, look at the business and its competitive landscape. A recent case study is in the Wall Street Journal today November 17th, Also, you should break-out growth from maintenance capex. The GAAP figures, of course, are the ones used in our consolidated financial statements. But, in our view, the GAAP figures are not necessarily the most useful ones for investors or managers. Therefore, the figures shown for specific operating units are earnings before purchase-price adjustments are taken into account. In effect, these are the earnings that would have been reported by the businesses if we had not purchased them. A discussion of our reasons for preferring this form of presentation is in the Appendix to this letter. This Appendix will never substitute for a steamy novel and definitely is not required reading. However, I know that among our 6, shareholders there are those who are thrilled by my essays on accounting - and I hope that both of you enjoy the Appendix. It should be emphasized that the two columns depict identical economics - i. And both "companies" generate the same amount of cash for owners. Only the accounting is different. So, fellow philosophers, which column presents truth? Upon which set of numbers should managers and investors focus? We will simplify our discussion in some respects, but the simplification should not produce any inaccuracies in analysis or conclusions. The contrast between O and N comes about because we paid an amount for Scott Fetzer that was different from its stated net worth. Under GAAP, such differences - such premiums or discounts - must be accounted for by "purchase-price adjustments. The first step in accounting for any premium paid is to adjust the carrying value of current assets to current values. In practice, this requirement usually does not affect receivables, which are routinely carried at current value, but often affects inventories. Assuming any premium is left after current assets are adjusted, the next step is to adjust fixed assets to current value. In our case, this adjustment also required a few accounting acrobatics relating to deferred taxes. Since this has been billed as a simplified discussion, I will skip the details and give you the bottom line: Had our situation called for them two steps would next have been required: The final accounting adjustment we needed to make, after recording fair market values for all assets and liabilities, was the assignment of the residual premium to Goodwill technically known as "excess of cost over the fair value of net assets acquired". Thus, the balance sheet of Scott Fetzer immediately before the acquisition, which is summarized below in column O, was transformed by the purchase into the balance sheet shown in column N. In real terms, both balance sheets depict the same assets and liabilities - but, as you can see, certain figures differ significantly. Save it to your desktop, read it on your tablet, or to your colleagues. The higher balance sheet figures shown in column N produce the lower income figures shown in column N of the earnings statement presented earlier. This is the result of the asset write-ups and of the fact that some of the written-up assets must be depreciated or amortized. The higher the asset figure, the higher the annual depreciation or amortization charge to earnings must be. The charges that flowed to the earnings statement because of the balance sheet write-ups were numbered in the statement of earnings shown earlier: The "new" Scott Fetzer pays exactly the same tax as the "old" Scott Fetzer would have, even though the GAAP earnings of the two entities differ greatly. And, in respect to operating earnings, that would be true in the future also. However, in the unlikely event that Scott Fetzer sells one of its businesses, the tax consequences to the "old" and "new" company might differ widely. As the years go by, similar charges to earnings will cause most of the premium to disappear, and the two balance sheets will converge. However, the higher land values and most of the higher inventory values that were established on the new balance sheet will remain unless land is disposed of or inventory levels are further reduced. See full PDF below. He is main reason behind the rapid growth of the business. Sheeraz previously ran a taxation firm. He is an expert in technology, he has over 5. Subscribe to Page 5

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7 Chapter 4 : Critical Steps & Analysis on a Capital Expenditure Analyzing Capital Expenditures blog.quintoapp.com teaching, studying, investing Page 2 A discussion of our reasons for preferring this form of presentation is in the Appendix to this letter. Capital Expenditures are the type of expenses that the entity spend on acquiring or upgrading long-term assets. The expenses could be recognized as or classed as capital expenditure only if those expenses are allow to be capitalize as long term assets according to accounting standard. In general, the expenses that treated as capital expenditure are for upgrading the existing fixed assets to get better performance, acquiring part of fixed assets as well as purchasing new fixed assets. Others expenses that are not allow to classify as capital expenditure are classified as operational expenditure OPEX. These kind of expenses are sometime called period cost of administrative costs. As you know, the building is the kind of fixed assets or long term assets in the Financial Statements. Build is depreciated annually based on the economic value that those building expected to be use for. Cost purchasing the new computer equipment are allowed to be capitalize as non long term assets. However, if the entity rend those assets for short term, then the expenses should class as operating expenses. Finance Leas might need to be checked against. Office Equipment are sometime treated as fixed assets and they are recording under the Capital Expenditure. However, Office Equipment are sometime records as operating expenditure based on entity accounting policy. Furniture and Fixture are the type of the capital expenditures. Land is the undepreciate fixed assets. Some of the company might own Machinery like manufacturing company and machinery is one of the big capital expenditures. Currently, technology is very importance for the success of the business and also the big proportion of expenses that inured in the company. Software is one of the most expenditure that happens in company. Software is also the Capital Expenditures. Vehicles are also the Capital Expenditures. The calculation of capital expenditures might look simple if you understand the two importance points above. One is the definition of it and another is familiarity with financial statements. You can calculate the capital expenditure by starting from Statement of Financial Position as well as the noted to its. If you ever touch the Statement of Financial Position, you can see the noted to PPE which is detail the amount of fixed asset brought forward, fixed assets purchased during the years, and fixed assets that had been dispose or written off. The Capital Expenditures during the period are those expenses for purchasing new fixed assets and upgrading the existing one. Why it is matter? Yet, the ways how the capital expenditure links to KPI and rewards might be the most importance things to note. Explanation, Formula, and Example The reason is when they invest in the new assets or upgrading, it is hard for them to hit the target. Capital Expenditures is the term use refer to expenses of or found to purchase fixed assets. Page 7

8 Chapter 5 : Financial Analysis, Investment Insight: Investment Analysis: Capital Expenditure Assume that you have received a capital expenditure request for $52, for plant equipment and that you are required to do a justification analysis using capital budgeting techniques. In every instance it involves improving efficiency and business capabilities. Deciding to move forward on a purchase must involve an understanding of the costs to operate the machine itself, its reputation for quality and its resale value. Afterwards, the process involves establishing criteria for evaluation as to the overall benefit of the purchase. This includes both consumables needed to operate the machine and its spare parts. Each of these plays a vital role in the overall cost of ownership. This information can be gathered from the market itself, competitors and complementary markets using the machinery. Therefore, it needs the machinery to increase production capacity and to lower its cycle times in manufacturing. So, what are the steps needed to perform the analysis? The company currently has a cycle time in manufacturing of 10 minutes. They produce 6 units every hour and 30 units per 5 hour shift. So, what does this decrease in cycle times mean to the company in terms of additional units produced and additional gross profit? Their new total produced per hour will be 8 units. The production increase means the company now manufactures 40 units per shift 8 units x 5 hours. However, the most important aspect of this increase is the increase in gross profit. Producing 2 additional units an hour, at the same labor rate, will increase gross profit. Here are the benefits summarized below in point form. In this example, the company runs 3 shifts a day, 5 days a week. Was it a good purchase? Establish the yearly increase in production capacity: Analyzing the pros and cons on a capital expenditure for production involves understanding the current production capacity with its cycle times and gross profit, and determining what the increase in production capacity will be from purchasing the equipment. Start with assessing current production levels and determining future production levels. Page 8

9 Chapter 6 : Capital Expenditures - Definition, Overview and Examples BREAKING DOWN 'Capital Expenditure (CAPEX)' In terms of accounting, an expense is considered to be a capital expenditure when the asset is a newly purchased capital asset or an investment that. The objective is to determine whether or not investing in real estate or upgrading existing equipment will produce an acceptable return on investment. Factors the business must consider are ownership costs such as maintenance and upkeep, the quality of the item and its future resale value. Set the Stage The first step in a capital expenditure analysis is a factual evaluation of the current situation. It can be a simple presentation of quantitative data or a more detailed evaluation that also includes qualitative data. Quantitative data can, for example, include current production rates, gross profit or cost information to describe the current situation. Qualitative data incorporates a more detailed description of current procedures or the current situation. It describes shortcomings, issues or problems the department is currently facing and may also include solutions the department may have previously explored and discarded. Justify the Expenditure A cost-benefit analysis is used to justify the expenditure and determine whether it makes sense from an operational perspective. This step includes a detailed cost analysis and a comparison of the costs involved to any potential benefits. This is especially critical if the expenditure will, for example, increase efficiency but may not immediately increase profits. For example, a benefits analysis looking to justify remodeling expenses for an existing warehouse might describe how the expenditure will increase storage capacity, allow for better organization and easier access to inventory items. Additional benefits might include an increase in overall efficiency, improved internal controls and increased customer satisfaction. Analyze the Risks A risk analysis exposes potential problems or issues the expenditure may impose. In the warehouse renovation example, additional storage space can increase inventory purchase costs and might lead to wasted space if economic conditions should cause sales to dip and require the business to reduce the numbers of inventory items on hand. Additional space and additional inventory items might also require the department to expand by one or more employees. A risk analysis ends by offering potential solutions to the exposed issues. Possible solutions in this example might be suggestions for using excess space and hiring seasonal or contract employees when sales are high and the inventory department requires additional help. Present Alternative Solutions The last step in a capital expenditure analysis is to present a list of alternative solutions. This list also includes potential consequences of choosing an alternative. Renting temporary storage space could be another possible alternative. This presents its own set of problems, however, because working from two locations can cause confusion and may cause the department to work even less efficiently than it would by doing nothing. Chapter 7 : Warren Buffett On Owner's Earnings - Analyzing Capital Expenditures Analyzing Capital Expenditures February 20, January 14, admin Posted in Uncategorized Assume that you have received a capital expenditure request for $52, for plant equipment and that you are required to do a justification analysis using capital budgeting techniques. Chapter 8 : Critical Steps & Analysis on a Capital Expenditure blog.quintoapp.com A Capital Expenditure (Capex for short) is the payment with either cash or credit to purchase goods or services that are capitalized on the balance sheet. Put another way, it is an expenditure that is capitalized (i.e. not expensed directly on the income statement) and is considered an "investment". Chapter 9 : Capital Expenditure CAPEX Adds to Capital Asset Base, unlike OPEX Capital Expenditures as a separate line item on a financial statement are important, as investors in a company are interested in the amount of capital improvements are being made to itself. Investors should be cautious of declining or Page 9

10 absent capital expenditures, as well as extraordinarily large values. Page 10