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CAPITAL BUDGETING

-By Aryan

Overview

This process helps in identifying and calculating capital projects. Capital projects are those projects where the expectation is that the firm receives the CF (cash flow) in a time duration spanning longer than a year. This structure helps in examining and analysing corporate decisions, making it the most important duty of a firm’s financial manager.

I say this because of the following 2 reasons:

- A firm has to purchase expensive assets for business purposes which are fixed in nature and have a long life and knowing this process can help in determining the upcoming success.

- Important corporate decisions can also be made by following this process as the aim is in line with the management’s goal of maximizing the value of the existing shareholders.

5 Key Principles

(1) Cash flows influence decisions, not accounting income:

  • - Incremental cash flow: relevant cash flows as part of the process
  • - Sunk costs: they cannot be avoided regardless of whether or not a project is undertaken
  • - Externalities: impact of acceptance on cash flows of other projects
  • - Cash flow pattern: it can be conventional (one or more outflows followed by one or more inflows) or unconventional (no set pattern for inflows and outflows)

(2) Cash flows are based on opportunity costs

(3) Timing of cash flows are important

(4) Cash flows are analysed on an after-tax basis

(5) Required rate of return reflects financing costs

Outlined Administrative Steps

(1) Idea Generation: Generating good ideas can be called the most important and foremost step in this process and their sources can be several from senior management to employees

(2) Analysing Project Proposals: A cash flow forecast can help in analysing whether a project is worth investing in based on estimated profitability

(3) Creation of a firm-wide budget: This step assists the firm in ranking all potential projects based on feasibility and profitability

(4) Decision Monitoring & Post-Audit implementation: A thorough follow up is an absolute must as this concept is based on estimates and not on actuals. Errors made help in identifying the flaws and improving operations systematically