Capital Budgeting
Capital budgeting can be defined simply as the process of planning for projects on assets with cash flows of a period greater than one year.
The Importance of Capital Budgeting
· The firm becomes tied to the project and loses some of its flexibility during that period.
· Managers need to forecast the revenue over the life of that asset.
· Capital-budgeting decisions ultimately define the strategic plan of the company.
Typical steps of Capital Budgeting
· Generate ideas
· Analyze projects
· Create the firm’s capital budget
· Monitor decisions and conduct a post-audit
Notes:
· Post-audit: improves future forecasts and efficiency of the operations.
Key principles of capital budgeting
· Incremental cash flows – sunk costs are not considered. Externalities including cannibalization of sales should be included.
· Opportunity costs of cash flows
· Timing of cash flow
· After-tax basis for cash flows
· Financing cost – reflected in the required rate of return but NOT in the incremental cash flows
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