Capital choose which one to invest in first.

Capital Budgeting

(FM) Financial Management

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Financial management is not just a one activity, it is
collection of a process, such as controlling, planning, directing and
organizing the financial transactions like procurement and effective use of
funds of the organization.

Objective of Financial Management

Financial management generally look into procurement,
controlling and allocation of financial resources within an organization.

·       
Supply of continues and sufficient funds.

·       
Full filing shareholders expectations of
providing sufficient return to them.

·       
Maximum utilization of funds at minimum cost.

·       
Investment should be done in safe side while
achieving sufficient required return of return.

·       
Maintaining of good capital is required to have
a balance of debt and equity of an organization.

 

 

Capital Budgeting

Definition- Capital budgeting is a
method of analyzing and comparing substantial future investments and
expenditures to determine which ones are most worthwhile. In other words, it’s
a process that company management uses to identify what capital projects will
create the biggest return compared with the funds invested in the project. Each
project is ranked by its potential future return, so the company management can
choose which one to invest in first.

Capital Budgeting: available from https://www.myaccountingcourse.com/accounting-dictionary/capital-budgeting (Accessed
25.01.2018).

Every financial company is looking expand their business. In
order to achieve that organization should have enough fixed assets or capital.
At this point organization required the help of capital budgeting.

Capital budget allow organizations to plan their fixed asset
sale and purchase. Usually the capital budgeting provide organizations to plan
their long term strategies and take decision to expand business. Company can
decide what type asset need to keep with them and what to sell in order spread
the business. Companies in order make decisions, management will use three main
analyzes such as throughput, discounted cash flows and payback analysis.

Main principles of Capital Budgeting

Decisions of capital budgeting are complex because of many
underlying assumptions. However most of the decisions are based on following
principles.

1.     
Decisions are Based on accumulated cash flows
not according to accounting income

 

Decisions of capital budgeting are based on
cash flows predicted without depending on accounting income. When the project
is accepted then additional Cash flows will occur, this is known as incremental
cash flows. When assuming incremental ash flows certain cost that incur will be
ignored such as sunk cost. Main reason to ignore the sunk cost is a cost that
already incurred whether project accepted or not. Likewise any kind of
intangible cost and benefits had been concerned.

Analysis should concern the externalities
when accounting the cash flows. This is Referring to the effect that generate
other than the project itself. Most common externality is one project reduces
the cash flow that generate from another investment and also there can be
positive externalities as well such as new project will have positive impact on
the revenue compared to another investment.

2.     
Timing of Cash flows

 

Another important factor in capital
budgeting is estimate the time of cash flows accurately as much as possible.  Time value of money concept is used by the
capital budgeting. The time that cash flow occur certainly have an impact on
the present value of the investment. More sooner cash flow occur is valuable.

 

3.     
Opportunity cost should be taken into
consideration

 

Opportunity cost should be taken into
consideration when new investment is considering.  Opportunity cost is the cost that incur due to
undertaking of new investment.

 

4.     
Post tax should be consider

Cash flow generated from new investment
should consider after deducting the applicable taxs from the cash flow.

 

5.     
Financing cost should be ignored

Financial cost will not be considering when
calculating cash flows. Analyst will consider after tax operating cash flows and
discounted using required rate of return to find out the net present value.

 

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