Question

1. 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

The purpose of capital budgeting is to evaluate the viability of the project or investment decision - generally with longer duration (more than a year)

There could be various parameters based on which a decision could be taken, such as :

-> Net Present value (based on an appropriate discounting factor, such as cost of capital)

-> Internal rate of return

-> Pay back period

-> Profitability Index

The four steps on evaluation of the project would be as follows :

1) Identify the alternative proposals or project opportunities. For instance, whether to purchase or lease a machine; selecting any one or combination of projects A,B,C; whether to sell

existing machine and buy a new machine etc.

2) Evaluate the alternative options - based on combination of parameters such as incremental earnings/savings, break-even period, IRR, NPV etc. Depending on the objective, even

qualitative factors could be taken into consideration such as environmental impact, brand value, welfare of the community etc.

3) Choose the best possible option - Based on the abovementioned criteria and methods the best alternative shall be selected

4) Execution of the project - The project is finally implemented. The progress must be regularly reviewed to ascertain if the actual performance is in line with the earlier assumptions made

Types of benefits to consider while evaluating a project could include the following aspects :

-> Incremental earnings or savings

-> Present value of the cash flow generation

-> Impact on the valuation of the firm

-> Pay-back period on investments

Qualitative factors such as market share expansion, impact on community and environment, brand image, risk diversification, government regulations etc. could also be considered