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The preparation of a capital-expenditure
budget must be preceded by an analytical and decision-making process by management. This area of managerial decisions not only is important to the success of the company but also is crucial in case of errors. Financial requirements, present and anticipated costs, profits, tax considerations, and legal, personnel, and market problems must be studied and reviewed before making the final decision.
Four evaluation techniques are generally accepted as representative tools for decision making: (1) payback- or payout-period method; (2) average-return-on-investment method; (3) present-value method; and (4) discounted-cash-flow method. None of these methods serves every purpose or every firm. The methods should, however, aid management in exercising judgment and making decisions. Of significance in the evaluation of a capital expenditure is the time value of money which is employed in the present value and the discounted-cash-flow methods. The present value means that a dollar received a year hence is not the equivalent of a dollar received today, because the use of money has a value. For this reason, the estimated results of an investment proposal can be stated as a cash equivalent at the present time, i.e., its present value. Present-value tables have been devised to facilitate application of present-value theory.
In the present-value method the discount rate is known or at least predetermined. In the discounted-cash-flow (DCF) method the rate is to be calculated and is defined as the rate of discount at which the sum of positive present values equals the sum of negative present values. The DCF method permits management to amortize corporate profits by selecting proposals with the highest rates of return as long as the rates are higher than the company’s own cost of capital plus management’s allowance for risk and uncertainty. Cost of capital represents the expected return for a given level of risk that investors demand for investing their money in a given firm or venture. However, when related to capital-expenditure planning, the cost of capital refers to a specific cost of capital from a particular financing effort to provide funds for a specific project or numerous projects. Such use of the concept connotes the marginal cost of capital point of view and implies linkage of the financing and investment decisions. It is, therefore, not surprising that the cost of capital differs, depending upon the sources. A company could obtain funds from (1) bonds, (2) preferred and common stock, (3) use of retained earnings, and (4) loans from banks. If a company obtains funds by some combination of these sources to achieve or maintain a particular capital structure, then the cost of capital (money) is the weighted average cost of each money source.
Return-on-Capital Concept This aids management in making decisions with respect to proposed capital expenditures. This concept can also be used for (1) measuring operating performance, (2) profit planning and decision making, and (3) product pricing. The return on capital may be expressed as the product of two factors: the percentage of profit to sales and the rate of capital turnover. In the form of an equation, the method appears as
Whether for top executive, plant or product manager, plant engineer, sales representative, or accountant, the concept of return on capital employed tends to mesh the interest of the entire organization. An understanding and appreciation of the return-on-capital concept by all employees help in building an organization interested in achieving fair profits and an adequate rate of return.
