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Outline of General Capital Budgeting Process

A.  Decide on Possible Capital Budget Projects

Generally speaking, capital budgeting projects can usually be classified into one of the following categories:

(1) replacement of existing equipment for maintenance purposes

(2) replacement for the purpose of cost reduction

(3) expansion of existing products or markets

(4) expansion into new products or markets

(5) safety and/or environmental projects

 

B.  Estimate Project Cash Flows - most difficult and most important step

(1) Capital Investment or Initial Outlay - cost of project (negative cash flows)

(2) Operating Cash Flows over life of project - typically the positive cash flows generated by the project (benefit of project)

(3) Terminal Cash Flows - any additional cash flow associated with the project's termination (salvage value)

This step will be explored in Chapter 12.

 

C.  Evaluate the Cash Flows using Capital Budgeting Decision Criteria

(1) Payback Period

(2) Net Present Value (NPV)

(3) Internal Rate of Return (IRR)

 

D.  Make the Accept/Reject Decision

 

E.  Post-Audit

The post-audit is a key element of capital budgeting. By comparing actual results with predicted results and then determining why differences occurred, decision makers can improve both their operations and their forecasts of projects' outcomes.

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