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Financial Management - Capital Budgeting (Q & A) - BBA - Semester 4 #BBANotes #ipumusings

Financial Management - Capital Budgeting (Q & A) - BBA - Semester 4

Financial Management - Capital Budgeting (Q & A) - BBA - Semester 4 #BBANotes #ipumusings

Q1. Define capital budgeting. Why is it important?

Answer: Capital budgeting is the process a business undertakes to evaluate potential major projects or investments. The process helps to determine whether capital assets are worth investing in.

According to Milton “Capital budgeting involves the planning of expenditure for assets and return from them which will be realized in the future time period”.

According to I. M. Pandey, “Capital budgeting refers to the process of generating, evaluating, selecting, and following up capital expenditure alternatives.” 

The advantages of investments come in the form of rising revenues or falling expenses, and capital expenditures require the long-term investment of sizable sums of money. Making the wrong choice in this area could have an impact on future wages, employment potential, quantity and quality of long-term planning and making the appropriate choice to incur or not to incur such one of management's most important responsibilities is the expense. The methods management employs in the process of carrying out this duty is referred to as capital budgeting.

Q2. What are the salient features of the capital budgeting process?

Answer: Important features of the Capital Budgeting Process:

(1) Long-term effect - 

Such decisions have a long-term effect on future profitability and influence the pace of a firm’s growth. A good decision may bring good returns and a wrong decision may endanger very survival of a firm.

(2) High degree of risk - 

A decision is based on an estimated return. Changes in taste, fashion, research and technological advancement lead to greater risk in such decisions.

(3) Huge funds – 

Large amounts/funds are required and sparing huge funds is a problem hence decision to be taken after proper care/analysis

(4) Irreversible decision – 

Reverting back from a decision is very difficult as a sale of high-value assets would be a problem.

(5) Most difficult decision – 

The decision is based on future estimates/uncertainty. Future events are affected by economic, political and technological changes taking place.

(6) Impact on firm's future competitive strengths – 

These decisions determine future profit/ cost and hence affect the competitive strengths of the firm.

(7) Impact on cost structure – 

Due to this vital decision, the firm commits itself to fixed costs such as supervision, insurance, rent, interest etc. If an investment does not generate anticipated profit, future profitability would be affected. 

Q3. What are the objectives of capital budgeting?


(1) Shareholder’s wealth maximisation. In tune with the objectives of financial management, its aim is to select those projects that maximize shareholders' wealth. The decision should avoid over/under-investment in fixed assets.

(2) Evaluation of proposed capital expenditure – Capital budgeting helps in evaluating expenditure to be incurred on various assets to measure the validity of each expenditure.

(3) Controlling costs - by evaluating expenditure costs can be controlled.

(4) Determining priority – arranging projects in order of their profitability enables the management to select the most profitable project. 

Q4. What are the factors that affect the capital budgeting process?


(1) Technological changes - Before implementing the capital budgeting process, the management must do a thorough analysis of the cost of new products and equipment as well as the productivity efficiency of both new and used equipment.

(2) Demand forecast - Before making any capital budgeting decisions, it will be necessary to analyse demand over a lengthy period.

(3) Competitive strategy: If a rival is pursuing innovative, highly functional and reasonably priced equipment, we might need to do the same.

(4) Type of management – If management is innovative, the firm may go for new types of equipment/investment as compared to conservative management.

(5) Cash flow – cash flow statement or cash budget helps a firm in identifying the time when a firm can make an investment in capital budgeting.

(6) Other factors- Like fiscal policy (tax concessions, rebate on investments) political salability, global situation etc.

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