Question

1. 5.1 Explain the process of capital budgeting. (3)

2. 5.2 Why is the process of capital budgeting necessary? (2)

Answer 1

5.1) Essentially Capital budgeting is a decision making technique of how to allocate scarce resources among various projects and generate the maximum amount of profit or shareholder wealth for the company, however, the same concepts can be applied in different types of decision making such as working capital, leasing, M&A, security valuation and so on and thus it is an essential concept of financial theory.

The process of Capital budgeting can be generalized as follows:

1. Identifying opportunities: the company looks out for projects which can be invested in to generate profits and increase shareholder value.
2. Analyze opportunities: Opportunities identified are analyzed based on several assumptions regarding their cash flows, growth rate, discount rate and other factors to gauge their profitability
3. Viability: the company tries to see how does the project fit within the company along with other projects. Some projects might be profitable individually, however, they might have cannibalizing effect on the outcome of other projects and therefore should not be undertaken.
4. Best fit projects are invested in, their performance is periodically or constantly reviewed, to see whether they are meeting the expectations and if not then how much loss can be expected and what would be the best way to reduce the same.

5.2) Capital budgeting is important because:

• Not all projects are profitable and to prevent the company from investing in unprofitable ones. Further it is also import from the portfolio perspective and see how well it fits with other projects of the company.
• It is important because the shareholder's wealth is dependent upon the kind of projects the company invests in and maximizing the same is the topmost priority for any company.
• Projects once invested cant be uninvested without bearing a loss. So capital budgeting tries to minimize such losses.