Capital Budgeting: Don't Take Capital Expenditure Evaluation Lightly When Acquiring Fixed Assets, Warns Theodore Chen, Who Recommends the Discounted Corporate Cash Flow Method

Article excerpt

Making a wrong choice when acquiring capital assets could drain your firm's finances over a long period, since they can't readily be sold off to solve short-term cash flow problems. The capital budgeting process is, therefore, crucial--particularly to SMEs that can't afford to tie up money in under-utilised fixed assets. Yet a big proportion of firms in Hong Kong, where my university is located, don't use any scientific method to inform such decisions.

Capital expenditures usually fall into one or more of the following categories:

* Capacity expansion.

* Equipment replacement.

* Government regulation.

* Cost reduction.

* Efficiency improvement.

* Revenue generation.

Those in the first three categories usually don't call for the application of evaluation methods, while those in the last three do. An example of capacity expansion would be the hiring of extra staff to cope with increased business activity, resulting in the acquisition of office equipment for them. In the case of equipment replacement, no analysis is required if it's a like-for-like substitution. If not, the expenditure could fall within the efficiency improvement category. An example of spending in the government regulation category would include that on legally required safety devices.

Companies generally resort to one of the following four methods of evaluating capital expenditure:

* Payback period. This technique uses cash flows instead of accounting income and aims to determine the time it will take for the investment to be recouped. It considers neither the time value of money nor cash flows after the payback period.

* Accrued accounting rate of return. This method uses accounting income rather than cash flows, but it still ignores the time value of money.

* Internal rate of return (IRR). This determines a rate of return based on trial and error, equating the present value of net cash flows over the life of the project with the initial investment. Say a new piece of plant that cuts operating costs by 101,000 [pounds sterling] at the end of each year for five years incurs maintenance costs of 1,000 [pounds sterling] annually and the initial investment in it is 379,100 [pounds sterling]. Working it out by trial and error, the IRR happens to be ten per cent. Using the present value of the annuity at ten per cent for five years: 3.791 x (101,000-1,000 [pounds sterling])= 379,100 [pounds sterling]. This method is also flawed, as the net cash flow generated from the project each year is reinvested at the internal project rate (ten per cent in this case). …