Page 120 - DMGT409Basic Financial Management

Unit 7: Capital Budgeting

Notes

Note Capital budgeting involves:

1. The search for new and more profitable investment proposals

2. The making of an economic analysis to determine the profit potential of each
investment proposal.

7.2 Capital Budgeting Process

Figure 7.1: Exhibits Capital Budgeting Process

Project Project Project Project
Generation Evaluation Selection Execution

While steps are essential to any capital budgeting process, but individual situations of capital
budgeting may demand other steps relevant to the situation to make the process an effective
one:
1. Project Generation: Investment proposals of various types may originate at different levels
within a firm. The investment proposals may fall into one of the following categories.

(a) Proposals to add new product to the product line.
(b) Proposal to expand capacity in existing product lines.
(c) Proposals to reduce the costs of the output of the existing at any level; from top
management level to the level of the workers. The proposals may originate
systematically or haphazardly.

Notes Principles of Capital Budgeting
Capital expenditure decisions should be taken on the basis of the following factors:

1. Creative search for profi table opportunities: Profitable investment opportunities
should be sought to supplement existing proposals.
2. Long-range capital planning: It indicates sectoral demand for funds to stimulate
alternative proposals before the aggregate demand for funds is fi nalized.
3. Short-range capital planning: It indicates sectoral demand for funds to stimulate
alternative proposals before the aggregate demand for funds is fi nalized.
4. Measurement of project work: Here, the project is ranked with the other projects.
5. Screening and selection: The project is examined on the basis of selection criteria, such
as the supply cost of capital, expected returns alternative investment opportunities,
etc.
6. Retirement and disposal: The expiry of the life cycle of a project is marked at this
stage.

7. Forms and procedures: These involve the preparation of reports necessary for any
capital expenditure programme.

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