Capital Budgeting Part 1- Revision notes.docVIP

CAPITAL BUDGETING Capital budgeting is the process of evaluating and selecting long-term investments that are consistent with the goal of shareholders (owners’) wealth maximization. The process of planning significant outlays on projects that have long-term implications is known as Capital Budgeting. Capital expenditure planning, evaluation, and control, sometimes called as the capital budgeting. It involves long-term commitments of resources to realize future benefits. It reflects basic company’s objectives and has a significant, long-term effect on the economic well being of the firm. CAPITAL BUDGETING PROCESS Any idea under consideration is a proposal. A project is either a single proposal or a collection of dependent proposals that is economically independent of all other proposals. Example: A soft drink company willing to introduce the new product i.e. orange drink (proposal). It is considered as the new project if and only if the cash flows from orange drink have no impact on the cash flows of the existing product. Otherwise both the existing and orange drink will be considered as a single project. IMPORTANCE It affects the profitability of a firm. Its effect over a long time spans and inevitably affects the company’s future cost structure. Capital investment decision once made, are not easily reversible without much financial loss to the firm. It involves costs and the majority of the firms have scarce (limited) capital resources. DIFFICULTIES The benefits from investments are received in some future period and the future is uncertain. (Risk Involvement) Cost incurred and benefits received from the capital budgeting decisions occur in different time periods. (Time value of Money) It is not often possible to calculate in strict quantitative terms all the benefits or the costs relating to a particular investment decision. RATIONALE (Fundamental Reason) Every decision is made either to Enhance the Reve