Capital budgeting is the process of evaluating potential long-term investments available to a firm. It involves large initial expenditures, which hopefully increase firm profitability, producing incremental cash inflows for the firm in the future. Some examples of capital budgeting include: the purchase of new equipment, rebuilding existing equipment, purchasing delivery vehicles, constructing new buildings, renovating existing buildings, joint ventures, expanding into new markets, introducing new products to existing markets, cost-saving technologies, research and development, and similar activities.
The process of capital budgeting involves:
Identifying a potential investment project.
Estimating all incremental cash flows (both outflows and inflows) of the project.
Evaluating the projected future incremental cash flows using present value techniques.
Deciding whether to accept or reject the project.
If the project is accepted, implementing the project and then periodically comparing actual cash flows to projected cash flows as a means of continual improvement in the capital budgeting process.
Effectively identifying and implementing positive value projects is essential for a company to grow. In fact, in a world where most firms grow annually, any firm that does not engage in successful capital budgeting will fall behind and eventually go bankrupt. However, firms that do poor capital budgeting can also go bankrupt for accepting projects, which should have been rejected and rejecting projects, which should have been accepted. Proper capital budgeting decisions are important to shareholders because the positive present value of a project directly translates into increased shareholder wealth. Thus, capital budgeting is the most effective way for financial managers to achieve the goal of financial management that you learned about in the first week of this course.
One duty of a financial manager is to choose investments with satisfactory cash flows and rates of return. Therefore, a financial manager must be able to decide whether an investment is worth undertaking and must be able to choose intelligently between two or more alternatives. To do this, a sound procedure to evaluate, compare, and select projects are needed. This procedure is called capital budgeting.
Virtually all general managers face capital-budgeting decisions in the course of their careers. The most common of these is the simple yes versus no choice about a capital investment. Regardless of the type of project, however, certain principles of capital budgeting should always be considered. The most important of these principles are:
Focus on cash flows, not profits.
Focus on incremental cash flows.
Account for time.
Account for risk.
Now, write an essay discussing the meaning and importance of each of these principles as they apply to capital budgeting. Evaluate the importance of each principle and discuss the consequences of ignoring any of these principles.
You must use a minimum of three scholarly sources to support your discussion.
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