Capital Budgeting
CAPITAL BUDGETING
PRINCIPLES
Capital budgeting is the process of evaluating and implementing a firm’s investment opportunities, by virtue of properly identifying such investments that are likely to enhance a firm’s competitive advantage and increase shareholder wealth. A typical capital budgeting decision involves a large up-front investment followed by a series of smaller cash inflows. A typical capital budgeting process is focused around following basic principles:
1) Decisions are based on potential cash flows and not accounting income: If a project is undertaken and subsequently some relevant incremental cash flows are to flow out by virtue of such a capital budgeting plan, the relevant cash flows are to be considered as a part of the budgeting process, and the decisions on capital budgeting have to take such incremental cash flows into consideration, before properly evaluating such a capital budgeting plan. However, the sunk costs, which can’t be avoided, even by overlooking or avoiding such a capital budgeting plan, should not be considered for acceptance or rejection of the project.
However, while finalizing a capital budgeting decision, one needs to examine the impact of implementing such a plan on the cash flows of related activities undertaken by the same group, which has some synergy with the proposal for which the capital budgeting is being undertaken. If the sales of some related company within the same group are likely to face shrinkage following the implementation of such a plan, the capital budgeting plan should take such a potential cash inflow loss into account, before going for the proposed plan. In other words, if potential cash flows are likely to have a detrimental affect on the cash flows emerging out of existing business, both of them need to be examined carefully before finalizing the capital budgeting plan. Such a typical case, where an existing cash flow may suffer due to potential cash flow of the new/ improved facility is called
PRINCIPLES
Capital budgeting is the process of evaluating and implementing a firm’s investment opportunities, by virtue of properly identifying such investments that are likely to enhance a firm’s competitive advantage and increase shareholder wealth. A typical capital budgeting decision involves a large up-front investment followed by a series of smaller cash inflows. A typical capital budgeting process is focused around following basic principles:
1) Decisions are based on potential cash flows and not accounting income: If a project is undertaken and subsequently some relevant incremental cash flows are to flow out by virtue of such a capital budgeting plan, the relevant cash flows are to be considered as a part of the budgeting process, and the decisions on capital budgeting have to take such incremental cash flows into consideration, before properly evaluating such a capital budgeting plan. However, the sunk costs, which can’t be avoided, even by overlooking or avoiding such a capital budgeting plan, should not be considered for acceptance or rejection of the project.
However, while finalizing a capital budgeting decision, one needs to examine the impact of implementing such a plan on the cash flows of related activities undertaken by the same group, which has some synergy with the proposal for which the capital budgeting is being undertaken. If the sales of some related company within the same group are likely to face shrinkage following the implementation of such a plan, the capital budgeting plan should take such a potential cash inflow loss into account, before going for the proposed plan. In other words, if potential cash flows are likely to have a detrimental affect on the cash flows emerging out of existing business, both of them need to be examined carefully before finalizing the capital budgeting plan. Such a typical case, where an existing cash flow may suffer due to potential cash flow of the new/ improved facility is called