Capital Budgeting Details Information

Q. Define Capital Budgeting.

Define Capital Budgeting: Capital budgeting is the planning process used to determine an organization’s long term investments such as buy new machinery, replace machinery, establish new plants, promote, new products and research development projects are worth pursuing. It is budget for major capital, or investment, expenditures.

Many formal methods are used in capital budgeting including the techniques such as:

1. Accounting Rate of Return (ARR);

2. Payback Period (PBP)

3. Net Present Value (NPV)

4. Profitability Index (PI)

5. Internal rate of return (IRR)

6. Modified internal rate of return

7. Equivalent annuity

8. Real Options Valuation

Q. Discuss the use of ‘time value of money’ in capital budgeting:

The time value of money is important in capital budgeting decisions because it allows small-business owners to adjust cash flows for the passage of time. This process, known as discounting to present value, allows for the preference of dollars received today over dollars received tomorrow. Understanding some common capital budgeting techniques that use the time value of money can help you understand why this concept is so important in capital budgeting decisions.

Q. Discuss the techniques of capital budgeting:

Capital budgeting is the process most companies use to authorize capital spending on long‐term projects and on other projects requiring significant investments of capital. Because capital is usually limited in its availability, capital projects are individually evaluated using both quantitative analysis and qualitative information. Most capital budgeting analysis uses cash inflows and cash outflows rather than net income calculated using the accrual basis. Some companies simplify the cash flow calculation to net income plus depreciation and amortization. Others look more specifically at estimated cash inflows from customers, reduced costs, and proceeds from the sale of assets and salvage value, and cash outflows for the capital investment, operating costs, interest, and future repairs or overhauls of equipment.


Q. Discuss the importance of capital budgeting for taking investment decision: 

The importance of capital budgeting for taking investment decision:

1. Capital budgeting is an important task when large sum of money is involved to initiate a project which influences the profitability of the firm.

2. Long term investment once made cannot be reversed without significance loss of invested capital. If the investment becomes sunk and mistakes, it influences the whole conduct of the business for the years to come.

3. Investment decision are the base on which the profit will be earned and probably measured through the return on the capital.

4. A proper mix of capital investment is quite important to ensure adequate rate of return on investment calling for the need of capital budgeting.

5. The implication of long term investment decisions are more extensive than those of short run decisions because of time factor involved, capital budgeting decisions are subject to the higher degree of risk and uncertainty than short run decision.