Capital expenditure process The capital expenditure process involves:
- generation of investment proposals
- evaluation and selection of those proposals
- approval and control of capital expenditures
- post-completion audit of investment projects
Approval and control of capital expenditures
- The capital-expenditure budget (CEB) maps out the estimated future capital expenditure on new and continuing projects.
- The CEB has the important role of setting administrative procedures to implement the project (project timetable, procedures for controlling costs).
- Timing is important because project delays and cost over-runs will lower the NPV of a project, costing shareholder wealth
Highlights any cash flows that have deviated significantly from the budget and provides explanations where possible.
Benefits of conducting an audit:
- may improve quality of investment decisions
- provides information that will enable implementation ofimprovements in the project’s operating performance
- may result in the re-evaluation and possible abandonment of an unsuccessful project.
Fundamental problems of ARR in project valuation:
- Arbitrary measure which is based on accounting profit as opposed to cash flows. It therefore depends on some accounting decisions such as treatment of inventory and depreciation.
- Ignores timing of the earnings stream. No time value ofmoney concepts are applied, as equal weight is given to accounting profits in each year of the project’s life.