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Capital Budgeting Concepts

What are the purposes of capital budgeting?
What factors influence a capital budgeting analysis, and how do they influence it?
How is capital budgeting used in most organizations?
How does the time value of money influence financial decisions made by organizations?

What are the merits of using the market capitalization model in the assessment and evaluation of mutually exclusive investment opportunities available to an enterprise?

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> What are the purposes of capital budgeting?

The purposes of the capital budgeting process are:

1. To identify, assess and plan for the capital needs of the institution for a five-year period.
2. To provide a basis for determining alternative sources of funding for capital needs including choices for donors.
3. To provide a basis for the assessment of the impact of new capital expenditures on the operating budget.
4. To provide a system for accounting for the capital resources of the institution.

The annual capital budget is prepared for a fiscal year but is presented within a context of a five-year capital plan. Once specific capital expenditures are approved in the annual budget, the project or equipment item budgets will be available until they are expended. The timeframe for expenditures can be a few weeks or a matter of several months. The budget is available only for approved capital items and cannot be expended on operational or other capital needs.

> What factors influence a capital budgeting analysis, and how do they influence it?

The factors that influence are:

1.Business risk
2.Company's tax exposure
3.Financial flexibility
4. Management style
5.Growth rate
6.Market Conditions

1.Business Risk
Excluding debt, business risk is the basic risk of the company's operations. The greater the business risk, the lower the optimal debt ratio.

As an example, let's compare a utility company with a retail apparel company. A utility company generally has more stability in earnings. The company has les risk in its business given its stable revenue stream. However, a retail apparel company has the potential for a bit more variability in its earnings. Since the sales of a retail apparel company are driven primarily by trends in the fashion industry, the business risk of a retail apparel company is much higher. Thus, a retail apparel company would have a lower optimal debt ratio so that investors feel comfortable with the company's ability to meet its responsibilities with the capital structure in both good times and bad.

2.Company's Tax ...

Solution Summary

1300+ words explains the merits of using market capitalization along with time money value, purpose and influence of capital budgeting.

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