Capital Budgeting Flashcards
What is Capital budgeting?
Capital budgeting is the process of planning and controlling investments for long-term projects. It is this long-term aspect of capital budgeting that presents the management accountant with specific challenges
Most financial and management accounting topics (i.e. calculating allowance for doubtful accounts or accumulating product costs) concern tracking and reporting activity for a single accounting or reporting cycle (i.e. 1 month or 1 year)
By their nature, capital projects affect multiple accounting periods and will constrain the organization’s financial planning well into the future. Once made, capital budgeting decisions tend to be relatively inflexible
What does Capital budgeting applications include?
Capital budgeting applications include the following:
- Buying equipment
- Building facilities
- Acquiring a business
- Developing a product or product line
- Expanding into new markets
A firm must accurately forecast future changes in demand in order to have the necessary production capacity when demand for its product is strong, without having excess idle capacity when demand slackens
A capital project usually involves substantial expenditures. Planning is crucial because of possible changes in capital markets, inflation, interest rates and the money supply
What decisions must be considered in capital budgeting?
As with every other business decision, the tax consequences of a new investment (and possible disinvestment of a replaced asset) must be considered
All capital budgeting decisions need to be evaluated on an after-tax basis because taxes may affect decisions differently. Companies that operate in multiple tax jurisdictions may find the decision process more complex. Another possibility is that special tax concessions may be negotiated for located an investment in a given locale
What are the stages of capital budgeting?
The stages in capital budgeting are as follows:
- Identification and definition
- Search
- Information-acquisition
- Selection
- Financing
- Implementation
What is the Identification and definition stage of capital budgeting?
(Stages of Capital Budgeting)
Identification and definition (1st stage of capital budgeting) - those projects and programs that are needed to attain the entity’s objectives are identified and defined
For example: a firm that wishes to be the low-cost producer in its industry will be interested in investing in more efficient manufacturing machinery. A company that wishes to quickly expand into new markets will look at acquiring another established firm
Defining the projects and programs determines their extent and facilitates cost, revenue and cash flow estimation (this stage is the most difficult)
What is the Search stage of capital budgeting?
Stages of Capital Budgeting
Search (2nd stage of capital budgeting) - potential investments are subjected to a preliminary evaluation by representatives from each function in the entity’s value chain
Dismal projects are dismissed at this point, while others are passed on for further evaluation
What is the Information-acquisition stage of capital budgeting?
(Stages of Capital Budgeting)
Information-acquisition (3rd stage of capital budgeting) - the costs and benefits of the projects that passed the search phase are enumerated
- Quantitative financial factors are given the most scrutiny at this point. These include initial investment and periodic cash inflow
- Non-financial measures, both quantitative and qualitative are also identified and addressed
a. Examples include the need for additional training on new equipment and higher customer satisfaction based on improved product quality
b. Also, uncertainty about technological developments, demand, competitors’ actions, governmental regulation and economic conditions should be considered
What is the Selection stage of capital budgeting?
Stages of Capital Budgeting
Selection (4th stage of capital budgeting) - employing one of the selection modes (net present value, internal rate of return, etc.) and relevant non-financial measures, the projects that will increase shareholder value by the greatest margin are chosen for implementation
What is the Financing stage of capital budgeting?
Stages of Capital Budgeting
Financing (5th stage of capital budgeting) - sources of funds for selected projects are identified. These can come from the company’s operations, the issuance of debt or the sale of the company’s stock
What is the Implementation and monitoring stage of capital budgeting?
(Stages of Capital Budgeting)
Implementation and monitoring (6th and final stage of capital budgeting) - once projects are underway, they must be kept on schedule and within budgetary constraints
This step also involves determining whether previously unforeseen problems or opportunities have arisen and what changes in plans are appropriate
What are the steps in ranking potential investments within capital budgeting?
Capital budgeting requires choosing among investment proposals. Thus, a ranking procedure for such decisions is needed. The following are steps in the ranking procedure:
- Determine the asset cost or net investment
- Calculate estimated cash flows
- Relate the cash-flow benefits to their cost
- Rank the investments
What is the first step in ranking potential investments within capital budgeting?
Determine the asset cost or net investment:
The net investment is the net outlay (or gross cash requirement) minus cash recovered from the trade or sale of existing assets, with any necessary adjustments for applicable tax consequences. Cash outflows in subsequent periods also must be considered
Also, the investment required includes funds to provide for increases in working capital (i.e. the additional receivables and inventories resulting from the acquisition of a new manufacturing plant)
This investment in working capital is treated as an initial cost of the investment (a cash outflow) that will be recovered at the end of the project (i.e. the salvage value is equal to the initial cost)
What is the second step in ranking potential investments within capital budgeting?
Calculate estimated cash flows (period by period) using acquired assets:
a. Reliable estimates of cost savings or revenues are necessary
b. Net cash flow is the economic benefit or cost, period by period resulting form the investment
c. Economic life is the time period over which the benefits of the investment proposal are expected to be obtained as distinguished from the physical or technical life of the asset involved
d. Depreciable life is the period used for accounting and tax purposes over which cost is to be systematically and rationally allocated. It is based upon permissible or standard guidelines and may have no particular relevance to economic life. Since depreciation is deductible for income tax purposes, thereby shielding some revenue from taxation, depreciation gives rise to a depreciation tax shield
What is the third step in ranking potential investments within capital budgeting?
Relate the cash-flow benefits to their cost by using one of several methods to evaluate the advantage of purchasing the asset
What is the fourth step in ranking potential investments within capital budgeting?
The fourth and last step is to rank the investments
