Capital Budgeting - Introduction

Prerequisites

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1. Definition

Capital Budgeting refers to the planning process used to determine whether an organization's long term investments such as new machinery, replacement of machinery, new plants, new products, and research development projects are worth the funding of cash through the firm's capitalization structure (debt, equity or retained earnings).

Simple Definition: It is the process of making investment decisions in long-term assets.

2. Concept Explanation

Capital budgeting involves the entire process of planning expenditures whose returns are expected to extend beyond one year.

Key Features:

1. Exchange of current funds for future benefits: You spend money today to get returns in the future.
2. Long-term impact: Decisions affect the firm for many years.
3. Huge funds: Investments usually involve large amounts of money.

3. Why is it called "Capital Budgeting"?

• Capital: Refers to the long-term funds or assets of the firm.
• Budgeting: The process of planning and controlling expenditure.

So, Capital Budgeting is the budgeting of capital expenditures.

4. Examples of Capital Budgeting Decisions

• Purchasing a new machine to replace an old one.
• Opening a new branch in another city.
• Launching a new product line.
• Investing in a Research and Development (R&D) project.
• Buying a patent or trademark.

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Exam Pattern Questions and Answers

Question 1: "Define Capital Budgeting." (2 Marks)

Answer: Capital Budgeting is the process of evaluating and selecting long-term investments that are consistent with the goal of shareholder wealth maximization. It involves planning expenditures on assets whose cash flows are expected to extend beyond one year.

Question 2: "What distinguishes capital budgeting from working capital management?" (4 Marks)

Answer: Capital Budgeting:

1. Time Horizon: Long-term (more than 1 year).
2. Amount: Involves huge funds.
3. Nature: Strategic and often irreversible.
4. Examples: Buying land, machinery.

Working Capital Management:

1. Time Horizon: Short-term (less than 1 year).
2. Amount: Relatively smaller funds.
3. Nature: Operational and reversible.
4. Examples: Buying inventory, paying wages.

Summary

• Definition: Planning for long-term assets.
• Key Aspects: Large funds, long-term impact, future benefits.
• Goal: Maximize wealth by selecting profitable projects.

Quiz Time! 🎯

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