Question 2 (a)
Capital budgeting and the irreversibility of its decisions
4 marks
- Time to write
- About 8 minutes
From an older CBCS paper
Question
Question 2 (a) · 4 marksWhat is meant by capital budgeting ? Do you agree that "Capital Budgeting decisions are irreversible." ? Comment. 4
Reworded from the university paper; the task is the same. The original paper belongs to the University of Delhi. See DU's question bank.
Before you write
Read off the question and its marks
Read from the question
- What is meant…?Do…?Two asks in one question: answer both.
Write it in this order
- Read; underline the asks; jot your points 1 min
- 1 Meaning of capital budgeting 1½ marks 1 min
- 2 Irreversibility, with reasons 2 marks 5 min
- 3 Comment ½ mark 1 min
Easy marks
- Meaning of capital budgeting (step 1, 1½ marks): a clear definition and a line on what it covers. It opens the answer, so it takes a minute or two.
Short on time? Step 2 carries 2 of the 4 marks: guard its minutes.
Try it first. About 8 minutes for 4 marks. Write it out, then open the solution.
Solution
Hover or tap a marked figure, like 72,000, to see how it is made and where else it appears.
Meaning. Capital budgeting is the process of deciding on investment in long-term (fixed) assets whose benefits are expected over several years: selecting among investment proposals such as expansion, diversification, or research and development. It is often said to be the most important part of financial management, because these decisions affect the firm's profitability for a long period.
"Capital budgeting decisions are irreversible": agreed. Most capital budgeting decisions cannot be reversed: once taken, the firm cannot go back without absorbing heavy losses from abandoning a project midway, so they should be taken only after every detail has been evaluated. The reasons:
- Complex decisions: they rest on estimates of future cash flows that are difficult to predict.
- Heavy outlays: a large part of the firm's funds is committed, and a wrong decision can cause heavy capital losses.
- Long-term commitment: the decision commits the firm to future funding needs and future consequences.
Comment. Irreversibility is a matter of degree (an asset can sometimes be sold or redeployed), but the cost of reversing is usually high. It is why such decisions call for careful estimation of cash flows and the use of sound appraisal techniques before the commitment is made.
Where the 4 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Meaning of capital budgeting | 1.5 |
| 2 | Irreversibility, with reasons | 2 |
| 3 | Comment | 0.5 |
| Total | 4 |
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