Basic Principles of Capital Budgeting | CFA Level 1 - AnalystPrep (2024)

FAQs

What are the basic principles of capital budgeting? ›

Capital budgeting typically adopts the following principles: decisions are based on cash flows, not accounting concepts such as net income; the timing of cash flows is critical; cash flows are based on opportunity costs.

The typical steps in the capital budgeting process are: 1) generating ideas, 2) analyzing individual proposals, 3) planning the capital budget, and 4) monitoring and post-auditing.

However, there are several unique challenges to capital budgeting. First, capital budgets are often exclusively cost centers; they do not incur revenue during the project and must be funded from an outside source such as revenue from a different department.

Capital allocation describes the process companies use to make decisions on capital projects, i.e., projects with a lifespan of one year or more. It is a cost-benefit exercise that seeks to produce results and benefits which are greater than the costs of the capital allocation efforts.

Capital budgeting is used by companies to evaluate major projects and investments, such as new plants or equipment. The process involves analyzing a project's cash inflows and outflows to determine whether the expected return meets a set benchmark.

A basic rule in capital budgeting is that if a project's NPV exceeds its IRR, then the project should be accepted.

Current assets less current liabilities equals working capital.

A simple method of capital budgeting is the Payback Period. It represents the amount of time required for the cash flows generated by the investment to repay the cost of the original investment. For example, assume that an investment of $600 will generate annual cash flows of $100 per year for 10 years.

(money)?” The two major drawbacks are, it ignores all cash flow after the initial cash flow is recovered and it ignores the time value of money. Many companies use payback for small dollar decisions.

What is the formula for capital budgeting? ›

How to calculate the present value factor in capital budgeting ? The present value factor can be calculated using the formula: PVF = 1 / (1 + r) ^ n, where r is the discount rate, and n is the number of periods.

Five Key Principles in Capital Allocation Process

Cash flows, not accounting income: Cash flows reflect the actual money exchanged during transactions, while accounting income, like net income, might include non-cash items like depreciation expense and amortization. Stick to cash flows for capital allocation decisions.

There are several ways to allocate capital. Some of the most common include mergers and acquisitions, capital expenditures, and R&D.

Capital allocation is about where and how a corporation's chief executive officer (CEO) decides to spend the money that the company has earned. Capital allocation means distributing and investing a company's financial resources in ways that will increase its efficiency, and maximize its profits.

Capital budgeting involves identifying the cash in flows and cash out flows rather than accounting revenues and expenses flowing from the investment. For example, non-expense items like debt principal payments are included in capital budgeting because they are cash flow transactions.

The Bottom Line

Capital expenditures are purchases made by a company and capitalized on a balance sheet rather than being fully expensed at the time of purchase. Assets that are capitalized can be accounted for over their useful lifetime and depreciated.

A: The five major principles of finance are time value of money, risk and return, diversification, capital budgeting, and cost of capital.