Question

1-In addition to high correlation between two variable, what's the other factor to consider the cause and effect?

2-What are the common types of relevant costs and irrelevant costs?

3-Generally, what is the time horizon for capital budget?

4-What factors other than quantitative are important to consider in making capital budget decisions?

5- Should a company accept all for investment proposals with positive NPV investment? Why or why not? What situation may a company should accept for investment all positive NPV investment alternatives?

Answer 1

1.

In addition to high correlation between two variables, the other factors considered are the:

Risk: the risk that the variable or project bears is one of the main factors to be considered. How much benefit or loss will be suffered by the company should be considered.

Return: the second main factor is returns. How much returns the company will be able to generate should be considered.

2.

Relevant cost:

This cost related to specific projects of the company. Relevant costs tend to change if the decision of the company changes in future. These costs are incurred by the company for a specific decision.

The examples of relevant costs are:

Opportunity cost: This costs refers to the costs that is given up to choose the next best alternative

Avoidable costs: This cost refers to the cost that can be avoided by the company in order to implement a capital budgeting project.

Free cash flows of the company: This refers to the cash from operating business of the company.

Incremental costs: This refers to the cost which is added by each unit of product produced.

Irrelevant costs:

The examples of irrelevant cost are:

Sunk costs: This is the cost that is already incurred by the company and cannot be recovered in any ways by the company.

Overheads: These are fixed and variable overheads, which the company has to incur in any situation and cannot avoid it.

Non cash expenses: these are the expenses which the company incurs in present financial year, but it relates to another accounting year.

Committed costs: this cost is the costs that are specifically committed in relation of a specific project and no other use of such project will be there for the company.

This cost is cost which would not affect the decision of the management in any ways. Such costs are ignored which the management takes a decision regarding any project to continue or close. This cost does not alter the decision of the management.

3.

Capital budgeting is the process to take decision regarding the capital budget of the company. The time horizon refers to the future period for which the budget is prepared. It can be of two types:

Long period: generally ranging from 5 to 20 years and Short period: making decision till the next accounting period i.e. 12 months.

4.

The factors that affect the capital decision making other than quantitative factors are qualitative factors:

These factors are:

The decision of capital investment, i.e. investment in fixed assets.

The technology used or to be used.

The commitment of the management towards the projects

The culture which the company follows

The quality of the products which the company offers

5.

Net present value (NPV) is the most common capital budgeting tool which takes into consideration the discounted cash flows of the company. In this the cash inflows of the project are deducted from cash outflows of the project, to determine the NPV.

There are different types of projects are on that basis the projects are selected. In case of independent projects, the project with positive NPV is selected and the project with negative NPV is rejected. In case of mutually exclusive project, the project with highest NPV is selected.

So, it can be said that all the projects with positive NPV are not selected; rather it depends on the type of project i.e. independent or mutually exclusive. The company should accept all the alternatives with positive NPV when the company has unlimited resources.