Question 4 (a)

Factors to be considered in a capital budgeting decision

5 marks

Time to write: About 10 minutes

From an older CBCS paper

Question

Question 4 (a) · 5 marks

Explain the factors to be considered when making a capital budgeting decision.

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

10 minfor 5 marks

Read from the question

ExplainEach point stated, then explained in a line or two.

Write it in this order

Read; underline the asks; jot your points 1 min
1 Goals, and costs and benefits measured as incremental cash flows 1½ marks 2 min
2 Required rate of return, project life and tax effects 2 marks 3 min
3 Size, irreversibility, risk, and the evaluation technique 1½ marks 2 min
Check: every ask answered, key terms underlined 2 min

123

Short on time? Trim steps 1–3 evenly rather than skip one: each is capped at its own marks.

Try it first. About 10 minutes for 5 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.

A capital budgeting decision commits large funds for a long time, is hard to reverse, and rests on uncertain estimates of future cash flows. The finance manager therefore weighs the following factors.

Fit with long-term goals (strategic or tactical). A strategic investment, such as entering a new product market, cannot be judged on cash flows alone: intangible benefits in line with the firm's long-term goals also count. A tactical investment mainly affects cash flows and carries less risk.
Costs and benefits of the proposal. The cost is the capital expenditure needed to install the project; the benefits may be higher output or sales, or savings in labour and wastage. Estimating them is the most important step. Only the incremental cash flows that result from accepting the project are relevant, not accounting profit.
Required rate of return (cost of capital). It adjusts future costs and benefits for the time value of money and is the yardstick of the proposal's profitability.
Life of the project. The economic life is set by technological obsolescence, physical deterioration and a decline in demand for the product.
Tax effects. Depreciation involves no cash outflow, but the tax it saves (the depreciation tax shield) is a cash inflow and must be counted.
Size, irreversibility and risk. Heavy outlays block a large part of the firm's funds; most such decisions cannot be reversed without heavy loss; and future cash flows are uncertain. So every detail is evaluated before the decision.
The evaluation technique. A proper technique (payback, ARR, NPV, IRR, profitability index) is applied to choose among the alternatives.

Where the 5 marks sit

#	Component	Marks
1	Goals, and costs and benefits measured as incremental cash flows	1.5
2	Required rate of return, project life and tax effects	2
3	Size, irreversibility, risk, and the evaluation technique	1.5
	Total	5

Keyboard: ← → previous and next question, / search

Report a problemopens an email to admin@getkunji.com with the question ID4960-Q4aalready filled in.