Question

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some considerations should be taken into account when doing capital budgeting: incremental earnings, interest expenses, taxes, opportunity costs, externalities, sunk costs, cannibalization or erosion, depreciation, salvage value, and others. explain in detail what defines capital budgeting. Then explain how two of the considerations above affect capital budgeting.

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Answer 1

Capital Budgeting is the process used by businesses for evaluation of capital investment decision like investment in a new plant & machinery, expansion of existing production site etc.

There are various elements that impacts capital budgeting. Following two elements affect the capital budgeting as follows:

1. Incremental earnings: More the incremental earnings faster the payback for the investment made. Therefore, it is important to identify and assess the quantum of incremental earnings from the project undertaken. For example: If additional machinery is added in the plant, how many additional units plant can manufacture (increase in manufacturing capacity) and sell (increase in sales capacity) ? And therefore, how much incremental revenue can be earned by selling those additional units ? More the incremental revenue better the return on investment and better pay back period.

2. Sunk Cost: These are the costs that has no impact on the capital budgeting as these costs are already incurred and does not impact the go - no go decision for the project as amount spent cannot be recovered by any action or non-action. For example: Research cost incurred to understand the expansion potential for the plant, cost of architecture for developing the design of the expansion (incurred at the time of original plant design).