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 a process used to evaluate major projects and investments for e.g. Investment in new Asset. It involves analyzing a project's inflows and outflows to assess whether the expected return from project meets organization's cut off criteria. Major methods of Capital budgeting are analyzing discounted cash flows and Payback period which are explained as below:

• Discounted Cash Flow(DCF) Analysis: This method analyzes initial outflow of project and future inflows and outflows and future inflows and outflows are discounted using organization's desired rate of return and a value is arrived which is called 'Net Present Value'(NPV) . Projects with higher NPV's are given preference over others unless if projects are mutually exclusive.
• Payback period Analysis : It is a simple form of capital budgeting but less accurate. This analysis calculates how much time it will take to recover the initial investment in the project. Payback period is arrived by dividing the Initial amount of investment by average yearly net inflow the project will generate.

Considerations in Capital Budgeting

1. Sunk Costs: Sunk costs are costs which are already incurred and are therefore irrelevant in capital budgeting analysis. For e.g. A business incurs $20 million in doing unavoidable research prior to making an investment. Hence, Sunk costs are incurred irrespective of whether to decide in favour or against making an investment in project.
2. Opportunity Costs: Opportunity costs are incremental costs or revenue foregone by a business due to investing in particular projects. Opportunity cost is very much important to be considered in Capital budgeting Analysis. For e.g A business has rented out its warehouse and a new project requires the business to use its warehouse for that project. Hence, in this case the rent foregone by the business shall be considered as opportunity cost while evaluating worthiness of project in Capital budgeting analysis.