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Managerial Accounting Capital Budgeting. Concept of capital budgeting. Importance of capital budgeting in major decisions like replacement of machinery or equipment
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The term capital budgeting is used to describe how managers plan significant outlays on projects that have long-term implications such as the purchase of new equipment and the introduction of new products. Most companies have many more projects than can actually be funded. Hence, managers must carefully select those projects that promise the greatest future return. How well managers make these capital budgeting decisions is a critical factor in the long run profitability of the company.
Capital budgeting involves investment-a company must commit funds now in order to receive a return in the future. Investment is not limited to stocks and bonds. Purchase of inventory or equipment or inventory is also an investment. These investments are characterized by a commitment of funds today in the expectation of receiving a return in future in the form of additional cash inflows or reduced cash outflows.
What types of business decisions require capital budgeting analysis? Virtually any decision that involve in out lay now in order to obtain some return (increase in revenue or reduction in costs) in the future. Typical capital budgeting decisions include
Cost reduction decisions. Should new equipment be purchased to reduce costs?
Expansion decisions? Should a new plan, warehouse, or other facility be acquired to increase capacity and sales?
Equipment selection decision? Which of several available machines should be the most cost effective to purchase?
Lease of buy decisions? Should new equipment be leased or purchased?
Equipment replacement decisions. Should old equipment be replaced now or later?
Capital budgeting decisions tend to fall into two broad categories-screening decisions and preference decisions.
Screening decisions
relate to whether a proposed project meets some preset standard of
acceptance. For example, a firm may have a policy of accepting projects only
if they promise a retune of, say, 20% on the investment. The required rate
of return is the minimum rate of return a project must yield to be
acceptable.
Preference decisions
Relate to selecting from among several competing courses of action. To
illustrate, a firm may be considering several different machines to replace
an existing machine on the assembly line. The choice of which machine to
purchase is a preference decisions.
Investment commonly involve retunes that extend over fairly long period of time. Therefore, in approaching capital budgeting decisions, it is necessary to employ techniques that recognize the time value of money. A dollar is today is worth more than a dollar a year from now. The same concept applies in choosing between investment projects. Those projects that promise earlier returns are preferable to those that promise later retunes.
The capital budgeting techniques that recognize the above two characteristics of business investments most fully are those that involve discounted cash flows.
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