Question

define what does Capital budgeting mean to you? Discuss the five steps involved in the capital budgeting process with an illustrative example of how it would apply in your profession. Explain why if is important to evaluate capital budgeting projects on the basis of incremental cash flows?

Answer 1

Capital bugeting is a technique which pertains to evaluating alternative investment decisions basis the cash outflow and cash inflow involved in the project. Capital budgeting is very important in any business because before commencing any new project, a fair estimate of cash flows can be obtained which gives the company a chance to understand if the proposed proposal is profit making or loss making. In most cases, these are long term projects,usually irreversible and capital intensive in nature.

Generic steps involved in any capital budgeting excercise are as follows

- Identify the projects to be evaluated

- Identify the costs associated with the project i.e. Cash outflow (Eg - purchase of land, equipment, etc) and the related Cash inflow ( Eg - Sale of units, products, etc)

- Identify the expected rate of return for the project i.e. Discount Rate to determine the present value of cash flows

- Determine on which basis you wish to evaluate the proposal i.e. Net present value technique, Adjusted Net present value, Profitability Index Method, Payback period, Discounted pay back period, Internal rate of return.

- While undertaking capital budgeting cash flow concept is is used rather than Accounting profits. Accounting profit does not give a true picture since it ignores non cash items like depreciation.

Incremental cash flow assist in determining if a particular project is undertaken, then any incremental revenue is generated in the business or not. For instance, currently business is producing 1000 as revenue. However, if a new machine is added Revenue will be 1500. So 500 is the incremental benefit. But the company has to determine if incremental benefit is justified by the capital outlay.  

Sometimes it's more viable to compare two projects on the basis of incremental cash flow technique.

It gives a picture as to which project has a higher inflow on net basis.

For eg - Project A generate Revenue of 100 but operating cost is 30, Net inflow = 70

Project B generate Revenue of 120 but operating cost is 60, Net inflow = 60

Even though with a higher share of revenue Project B is not a good proposition.

Comparing incremental cash flow is easier.