Question

Describe capital budgeting. Use a real company and give an example of a type of investment that might come from this. Make sure to explain the level of risk associated with your chosen investment.

Answer 1

Capital budgeting is a company's formal process used for evaluating potential expenditures or investments that are significant in the amount. It involves the decision to invest the current funds for addition,disposition, modification or replacement of fixed assets. The large expenditures include the purchase of fixed assets like land and building, new equipment, rebuilding or replacing existing equipment, research and development,m etc. The large amounts spent for these types of projects are known as capital expenditures. Capital budgeting is a tool for maximizing a company's future profits since most companies are able to manage only a limited number of large projects at any one time.

Capital budgeting usually involves calculation of each project's future accounting profit by period, the cash flow by period, the present value of cash flows after considering time value of money, the number of years it takes for a project's cash flow to pay back the initial cash investment, an assessment of risk, and various other factors.

Features are- It involves high risk, large profits are estimated, long time period between the initial investments and estimated returns.

Full example-- Capital budgeting for a dairy farm expansion involves three steps: recording the investment's cost, projecting the investment's cash flows and comparing the projected earnings with inflation rates and the time value of the investment. For example, dairy equipment that costs $10,000 and generates a $4,000 annual return would appear to pay back on the investment in 2.5 years. However if economists expect inflation to rise 30% annually, then the estimated return value at the end of the first year ($14,000) is actually worth $10,769 when you account for inflation ($14,000 divided by 1.3 equals $10,769). The investment generates only $769 in real value after the first year.