Chapter 8 - Pearson Learning Solutions

324 PART THREE Long-Term Investment DecisionsTABLE 8.1MotiveExpansionReplacementor renewalOther purposesKey Motives for Making Capital ExpendituresDescriptionThe most common motive for a capital expenditure is to expand the level of operations—usually throughacquisition of fixed assets. A growing firm often needs to acquire new fixed assets rapidly, as in thepurchase of property and plant facilities.As a firm’s growth slows and it reaches maturity, most capital expenditures will be made to increaseefficiency by replacing or renewing obsolete or worn-out assets. Renewal may involve rebuilding, overhauling,or retrofitting an existing fixed asset. Each time a machine requires a major repair, the outlay forthe repair should be compared to the outlay to replace the machine and the benefits of replacement.Some capital expenditures do not result in the acquisition or transformation of tangible fixed assets. Instead,they involve a long-term commitment of funds in expectation of a future return. These expendituresinclude outlays for advertising campaigns, research and development, management consulting, and newproducts.2. Review and analysis. Formal review and analysis is performed to assess theappropriateness of proposals and evaluate their economic viability. Once theanalysis is complete, a summary report is submitted to decision makers.3. Decision making. Firms typically delegate capital expenditure decision makingon the basis of dollar limits. Generally, the board of directors must authorizeexpenditures beyond a certain amount. Often plant managers are givenauthority to make decisions necessary to keep the production line moving.4. Implementation. Following approval, expenditures are made and projectsimplemented. Expenditures for a large project often occur in phases.5. Follow-up. Results are monitored, and actual costs and benefits are comparedwith those that were expected. Action may be required if actual outcomesdiffer from projected ones.Each step in the process is important. Review and analysis and decision making(Steps 2 and 3) consume the majority of time and effort, however. Follow-up(Step 5) is an important but often ignored step aimed at allowing the firm toimprove the accuracy of its cash flow estimates continuously. Because of theirfundamental importance, this and the following chapters give primary considerationto review and analysis and to decision making.Personal Finance ExampleIndividuals can approach the acquisition of major assets much as do corporations.Using the five-step process:1. A personal financial plan or a special situation initiates the proposed assetpurchase. For example, your personal financial plan specifies a new car purchasein 2010.2. Review and analyze the proposed asset purchase to isolate attractive alternativesin terms of features and costs. For the car purchase, you would shop forcars with the desired features and costs that are consistent with the budgetedamount.3. Compare the features and costs of the alternative assets and choose the preferredalternative. That is, you would decide which car you are going to buy.4. Make the purchase. This would involve arranging financing/payment for thecar, possibly negotiating a trade-in price, closing the transaction, and takingdelivery of the new car.2008935971Principles of Managerial Finance, Brief Fifth Edition, by Lawrence J. Gitman. Copyright © 2009 by Lawrence J. Gitman. Published by Prentice Hall.