Capital expenditure (CAPEX) refers to the capital expense of a company or a business firm which incurs this expense to avail some long-term benefits. The benefits from this expenditure reaps over very long period of time for the company and the investors as well. This type of expenditure doesn’t expire in a short period of time. Acquisition of permanent assets and clearing of long term liabilities are the main types of capital expenditures. This type of expenditure is also non-recurring in nature ad is very different from the recurring expense.
In simpler terms, we can define capital expenditure as a capital expenditure is basically making of a major financial stop or decision about the business firm or the company. Some of the main steps of this type of expenditure is starting of a new branch, make or buying the decisions as per the conditions and need, building of a new plant and maintaining it and purchase of new machineries.
Capital expenditure budgeting is basically the decisions which have to be taken for making a long-term investment for the firm or the company. These are the important decisions which have to be undertaken to finance the needed investment. Capital Budgeting is helpful in estimating the future cash flow in the company, analyzing and deciding how to finance the project the company or firm is working upon and also in making decisions on an appropriate interest rate which have discounting with those cash flows.
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Capital budgeting is an essential part of the planning process of a firm’s well-being and good future. These are the needs for having a good capital budget:
1. As long term investments and capital expenditure is incurred, it involves a large part of the company’s money hence a proper and good capital budgeting is much needed one. The large sum of money which is involved in this accounted for the profitability and accountability to the company’s future. Hence, this makes capital budgeting an important task.
2. The long-term investments which are to be made or are made cannot be reversed back due to the rigid nature of this expenditure. The result will either b profit or loss to the firm. If there is not a good capital budget on the capital expenditure the risk factors rise naturally, hence affecting the present and future of the business firm. It affects the whole mindset and conduct of the business for coming years.
3. Long term investments have usually more implications than the short-term investments and as a result implies the same with the decisions which are associated with the long term and short term investments. It is usually because of the time factor which is involved in these types of decisions. Hence, capital budgeting has a higher risk and degree of uncertainty than the decisions made with the short-term investments.
4. On the whole, the decisions which are made upon the investment process are based wholly on the main thing on which the profit will be earned continuously. It is measured through the return which is earned on the capital. Capital expenditure is very essential for ensuring the good and adequate rate of return on investment which eventually is calling for a capital budgeting.
There are some tools which are used extensively for making of the decisions on the capital expenditure, these are:
Net present value or NPV is the total value in current standards’ dollars of future payments which is received at a discount rate which is predetermined. Usually, the capital budgeting projects are showcased as the mutually exclusively projects and sometimes as the independent project. An independent project is mainly the sole d individual project in which the cash flows are not really much affected or altered by the acceptance or rejection decision with the respect of other project works. And according to this, each and every independent project which influence the capital budgeting are accepted initially. On the other hand, the mutually exclusive projects are the set of different and important topics which are at most chosen in between. Sometimes it complies same set of project decisions which makes the same task accomplishment.
Internal rate of return or the IRR is a tool which helps in determining the discount rate which equates with the net present value to zero. This is a rate which gives a net present value to the firm to the zero. This tool is mainly used to measure the investment efficiency of the firm. The IRR is a vast method to identify potential efficiency plans and decisions. Usually the IRR method gives the same result as the NPV method for the independent and individual projects which are conducted in a very constraint environment. Usually in a situation like this, there is first a negative cash flow but is followed by a positive and strong cash flows.
The Equivalent annuity method or also known as the EAM, is a method which expresses the current Net present value which is determined as a cash flow with the annual constant. It is usually used when the company is assessing only the main costs of specific projects which have the same cash inflows and charts. It is called as the equivalent annual cost method which stats it to be the cost per year of owning as well as operating a single asset and using it to its fullest extent. The main use of the equivalent annual cost method mainly implies with the replacement of the project with on which an identical is and with same prospects. The assumption factor of the same cash flows for each and every link which is present in the chain and cycle is importantly have an assumption of zero inflation, hence as a result, they have real interest rate rather than a nominal interest rate which is commonly used in the calculations.
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