Question

Discuss the purpose of capital budgeting. Elaborate on the four steps to follow when making a decision about a major purchase or project and on the types of benefits to consider when evaluating a major purchase or project. (160 words)

Answer 1

Capital budgeting are long term decisions made with an investment to get benefits. It is long term in nature and irreversible. It involves initial outlay and receiving periodical benefits over hte time frame of the project. Capital budgets are analyzed based on cost benefit ratio and with various techniques of evaluation like payback, accounting rate of return, net present value, profitablity index and internal rate of return. A firm has to budget its capex investments and allocate resources to the projects yielding higher return on investment.

The following are the 4 steps in evaluation of capital budgeting

· Understand and compute the benefits of projects

· Understand and compute the costs of project

· Computation of projected cash flows based on time period of project

· Analyse cost benefit with help of various techniques of capital budgeting.

There are 2 types of benefits to be considered in evaluation of capital budgets

· Increase in revenue

· Decrease in operating costs