As capital budgeting involves substantial initial outlay and years( at least more than one year) to reap the benefits, it is critically important to understand some of the cardinal principles or rules or guidelines when performing this capital budgeting exercise.
Append below in brief pertaining to:
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GUIDELINES/PRINCIPLES ON THE CAPITAL BUDGETING ANALYSIS
Guideline No1: Use Cash Flows And Not Accounting Profit. Remember that profit is not equating to cash. You need to adjust accounting profit to arrive at the relevant cash flows
Guideline No 2: Focus on Incremental Cash flows. Simply it means that you should compare the total cash flows of the company with and without the project. After determining the incremental cash flows, you need to consider the tax implication on these cash flows viz focus only on “after-tax incremental cash flows” in the capital budgeting analysis.
Guideline No.3: Consider any synergistic effect on the project for example when this new product the firm is going to introduce, will the sales of the existing products also increase- are they complementary to each other. In financial terms therefore we need to consider the sales of the new products Plus the increase in sales of the existing products
Guideline No.4: Consider the opposite of rule no 3 re: the existing sales might reduce with the introduction of the new products. Factored the loss of revenue from such existing products into the capital budgeting analysis
Guideline No.5:
Ignore sunk costs and consider only those costs which are relevant to the projects.
Guideline No.6: Incorporate any NET additional working capital requirements into the capital budgeting analysis for example the need to have additional inventories, accounts receivables and or cash (increase in current assets) minus additional financing from accounts payable, bank borrowings(current liabilities)
Guideline No.7: Excludes Interest Payments as this is already reflected in the discount rate ( this rate implicitly accounts for the cost of raising the financing ) |