CONTEMPORARY ISSUES IN MANAGEMENT ACCOUNTING (DAC406)
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CAPITAL BUDGETING
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CONTEMPORARY ISSUES IN MANAGEMENT ACCOUNTING (DAC406)
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The University Of Nairobi
Book
Cost and Management Accounting
The evolution of some of the key issues related to capital budgeting makes it clear that informational impediments is a fundamental theme that has dominated much of the capital budgeting literature over the last sixty years. This presentation reviews the literature espousing this theme in the conte...
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UNIVERSITY OF NAIROBI
SCHOOL OF BUSINESS
Department of finance and accounting
Contemporary Issues in Management Accounting
COURSE UNIT: DAC 406
Capital budgeting and informational impediments:
A management accounting perspective
Abstract:
The evolution of some of the key issues related to capital budgeting makes it clear that
informational impediments is a fundamental theme that has dominated much of the capital
budgeting literature over the last sixty years. This presentation reviews the literature espousing this
theme in the context of the following three specific, albeit related, issues:
o the use of sophisticated methods for selecting capital investments;
o asymmetric information and capital budgeting;
o Post-auditing capital investments.
The presentation also discusses the role that management accounting systems (MAS) can play to
help mitigate the informational impediments to capital budgeting. It takes a broad-scope view of
MAS, considering non-financial as well as financial information, ex ante as well as ex post
information, and external as well as internal information.
Compiled by: CPA Paul Thegethi
1
,CAPITAL BUDGETING AND INFORMATIONAL IMPEDIMENTS.
Meaning:-
The term Capital Budgeting refers to the long-term planning for proposed capital outlays or
expenditure for the purpose of maximizing return on investments. The capital expenditure may be;
i. Cost of mechanization, automation and replacement.
ii. Cost of acquisition of fixed assets, land, building and machinery
iii. Investment on research and development.
iv. Cost of development and expansion of existing and new projects.
DEFINITION OF CAPITAL BUDGETING
Capital Budget is also known as "Investment Decision Making.” Normally such decisions where
investment of money and expected benefits arising there from are spread over more than one year, it
includes both raising of long-term funds as well as their utilization.
Charles T. Horngnen has defined capital budgeting as "Capital Budgeting is long-term planning for
making and financing proposed capital outlays."
In other words, capital budgeting is the decision making process by which a firm evaluates the
purchase of major fixed assets including building, machinery and equipment.
According to Hamption, John.1. "Capital budgeting is concerned with the firm's formal process for
the acquisition and investment of capital."
From the above definitions, it may be concluded that capital budgeting relates to the evaluation of
several alternative capital projects for the purpose of assessing those which have the highest rate of
return on investment.
Importance of Capital Budgeting.
1. Capital budgeting is important because of the following reasons;
2. Capital budgeting decisions involve long-term implication for the firm, and influence its risk
complexion.
3. Capital budgeting involves commitment of large amount of funds.
4. Capital decisions are required to assessment of future events which are uncertain.
5. Wrong sale forecast; may lead to over or under investment of resources.
6. In most cases, capital budgeting decisions are irreversible. This is because it is very
difficult to find a market for the capital goods. The only alternative available is to
scrap the asset, and incur heavy loss.
7. Capital budgeting ensures the selection of right source of finance at the right time.
8. Many firms fail, because they have too much or too little capital equipment.
9. Investment decision taken by individual concern is of national importance because it
employment, economic activities and economic growth.
Objectives of Capital Budgeting.
1) The following are the objectives of capital budgeting;
2) To ensure the selection of the possible profitable capital projects.
3) To ensure the effective control of capital expenditure in order to achieve by forecasting the
long-term financial requirements.
2
, 4) To make estimation of capital expenditure during the budget period and to see that the
benefits and costs may be measured in terms of cash flow.
5) Determining the required quantum takes place as per authorization and sanctions.
6) To facilitate co-ordination of inter-departmental project funds among the competing capital
projects.
Principles or Factors of Capital Budgeting Decisions.
1. A decision regarding investment or a capital budgeting decision involves the following
principles; a careful estimate of the amount to be invested.
2. Creative search for profitable opportunities.
3. A careful estimate of revenues to be earned and costs to be incurred in future in respect of
the project under consideration.
4. A listing and consideration of non-monetary factors influencing the decisions.
5. Evaluation of various proposals in order of priority having regard to the amount available
for investment.
6. Proposals should be controlled in order to avoid costly delays and cost over-runs.
7. Evaluation of actual results achieved against those budget.
8. Care should be taken to think all the implication of long range capital investment and
working capital requirements.
9. It should recognize the fact that bigger benefits are preferable to smaller ones and early
benefits are preferable to latter benefits.
THE PROCESS OF CAPITAL BUDGETING.
The following procedure may be considered in the process of capital budgeting decisions;
1. Identification of profitable investment proposals.
2. Screening and selection of right proposals.
3. Evaluation of measures of investment worth on the basis of profitability and uncertainty.
4. Establishing priorities- uneconomical or unprofitable proposals may be rejected.
5. Final approval and preparation of capital expenditure budget.
6. Implementing proposal- project execution.
7. Review the performance of projects.
Types of Capital Expenditure
Capital Expenditure can be of two types;
(a) Capital Expenditure Increases Revenue.
It is the expenditure which brings more revenue to the firm either by expanding the existing
production facilities or development of new production line.
(b) Capital Expenditure Reduces Costs.
Such a capital expenditure reduces the cost of present product and thereby increases the profitability
of existing operations. It can be done by replacement of old machine by a new one.
Compiled By: CPA Paul Thegethi
3
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