“Capital budgeting (also known as investment appraisal) is the process by which a company determines whether projects (such as investing in R&D, opening a new branch, replacing a machine) are worth pursuing. A project is worth pursuing if it increases the value of the company”.
In general a project typically does add a value to a company if it earns the expected return of the project which is greater than the cost of that project. Expected rate of return is known as the opportunity cost of any project. While capital budgeting is a fairly straightforward process from a conceptual viewpoint, it can be very challenging in practice. Not only is it difficult to determine the group's appropriate cost of capital, it is often even trickier to accurately forecast the incremental cash flows that result from taking on the project.
Attempting the Numerical of the Capital Budgeting
Whenever the capital budgeting problems are encounter they must be having data related to following accounts.
- Each problem should have the purchase price data. The alternative names for purchase price are initial cost, initial investment or simply cost. This accounts needs to be depreciated and the depreciation methods are either “straight line” or “accelerated rates”. And the depreciated value needs to be subtracted from the cash inflows. This account is also called as cash outflow account.
- The second account in these problems will mention the related cash inflows. The alternative name for cash inflow is Annual savings, Net savings.
- The third account could be related to the method of depreciation. Always remember that depreciation is applied on initial investments or purchase price or initial cost or cost. The problem mentions the method of depreciation also.
- The fourth account is cost of Capital which is also called discounting rate. These problems will mention the tax rate as well.
- While solving the capital budgeting problems we always go for operating cash flows. The method of calculating operating cash flows; identify the relevant cash inflows. This may be in the form of annual saving, or net saving. In the second row calculate the relevant depreciation amount.
December 08, 2019