An example of a capital budgeting decision is deciding:

A) how many shares of stock to issue.
B) whether or not to purchase a new machine for the production line.
C) how to refinance a debt issue that is maturing.
D) how much inventory to keep on hand.
E) how much money should be kept in the checking account.

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The Correct answer for the given question is Option B) whether or not to purchase a new machine for the production line.

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Answer Explanation for Question: An example of a capital budgeting decision is deciding:

Capital Budgeting Decision

Capital Budgeting is the process that a business uses to determine which proposed fixed asset purchases it should accept, and which should be declined. Capital budgeting is used by companies to evaluate major projects and investments, such as new plants or equipment. This process is used to create a quantitative view of each proposed fixed asset investment, thereby giving a rational basis for making a judgment. The process involves analyzing a project’s cash inflows and outflows to determine whether the expected return meets a set benchmark. The major methods of capital budgeting include discounted cash flow, payback, and throughput analyses.

In the above scenario the answer for the given question , An example of a capital budgeting decision is deciding would be whether or not to purchase a new machine for the production line. Capital budgeting is used by companies to evaluate major projects and investments, such as new plants or equipment. This process is used to create a quantitative view of each proposed fixed asset investment, thereby giving a rational basis for making a judgment.

Process of Capital Budgeting

Idea Generation : Creating good investment ideas is the most important part of the capital budgeting process. An organization’s investment ideas can come from many sources, including senior management, staff, or external sources.
Analyzing Individual Proposals: In order to determine the expected profitability of a project, a manager must gather information about the project’s cash flow. This is because a capital investment’s cash flow growth is what determines whether the investment is accepted or rejected.
Planning Capital Budget: A company should prioritize profitable projects based on the timing of the project’s cash flow, the company’s resources, and the company’s overall strategy. Individually promising projects might not be desirable from a strategic standpoint. Financial and resource issues make it important to prioritize and schedule projects.
Monitoring and Conducting a Post Audit: All capital budgeting decisions should be followed up or tracked by a manager. Compared to the projected results, he should explain why the projections did not match the actual performance. In order to identify systematic errors in the forecasting process and subsequently improve company operations, a thorough post-audit is essential.

Advantages of Capital Budgeting

Capital budgeting gives a company a better understanding of the risks associated with an investment opportunity and how these risks affect its returns.
Using this method, the company can determine which investment options will yield the highest return.
Various techniques of capital budgeting can be used to estimate whether a project will be financially viable for a company.
The company can make long-term strategic investments with it.
A well-informed decision about an investment can be made by considering all the options.
An organization in a competitive market can make wise investments with its help.
Capital budgeting techniques/methods all aim to increase shareholders’ wealth and give a company a competitive edge.
The capital budgeting process determines whether an investment will increase the value of a company.
It allows you to control expenditures for projects adequately.
This allows management to avoid both overinvesting and underinvesting.

Disadvantages of Capital Budgeting

Capital budgeting techniques presume that various investment proposals are naturally exclusive, a claim that may not hold true in all cases.
Capital budgeting requires estimating future cash flows and outflows. There is always uncertainty about the future, and data collected for that time may not be accurate. Obviously, the results based upon wrong data can be good.
Some factors, such as employee morale and goodwill, cannot be precisely quantified, but nonetheless have a significant effect on capital allocation decisions.
An additional limitation in evaluating capital investment decisions is the urgency factor.
Capital budgeting techniques are limited by uncertainty and risk.

Methods of Capital Budgeting

A) Payback period

Payback periods are the simplest way to budget for new projects. It indicates how long it will take for your project to generate enough inflows to cover your investment. A shorter payback period makes a project more appealing because it means that your investment costs can be recovered in a shorter period of time. Those who have a limited amount of funds to invest in a project and need to recover their initial investment before starting another are often drawn to the payback period method.It is very popular for evaluating capital expenditure projects because it is simple to calculate and understand. While it has some limitations, it ignores many important factors that should be considered when evaluating the economic feasibility of a project.

Payback in the number of years = Initial Investment/Cash flow per year

Payback period method is a method used by businesses to determine how much cash flow will come in from different projects, and which one will have the quickest return on investment.

Advantages of Payback Period

It’s an easy process:
Less data to crunch.
Small businesses can benefit from this method
Faster reinvestment of earnings.
Tip the Scales in a Difficult Decision.
Keeps Financial Liquidity.
Major losses can be prevented.
Multiple options can be managed.
Short-Term and Long-Term Opportunities.

Disadvantages of Payback Period

Payback period is the only consideration.
Budgets based on short-term goals.
It does not consider the time value of Investments.
Time Value of Money Is Ignored.
As a sole measure, payback period is not realistic.
Does not consider overall profit.
Cash Flows Only for Short-Term Use Are Considered.
For most investments, it is too simple.
A proper assessment of investments is lacking.

B) Average rate of return (ARR)

Accounting rate of return (ARR) is also known as return on investment (ROI). It measures the profitability of a potential investment based on accounting information obtained from financial statements. Considering the project’s earnings over its entire economic life, the ARR method is preferred by some companies.

Disadvantages

It does not take account of the timing of the profits from an investment.
It implicitly assumes stable cash receipts over time.
It is based on accounting profits and not cash flows. Accounting profits are subject to a number of different accounting treatments.
It is a relative measure rather than an absolute measure and hence takes no account of the size of the investment.
It takes no account of the length of the project.
It ignores the time value of money.

C) Discounted cash flow methods

A discounted method is also known as a time-adjusted technique. It takes into account the value of time when evaluating the costs and benefits of a project. The cost of capital is applied to the projected cash flows. As part of these methods, all benefits and costs associated with the project are taken into account.

D) Net present value (NPV)

Capital budgeting based on net present value measures whether a project is expected to be profitable. This method allows all projects with a positive net present value to be considered, but projects with a negative net present value are not. A popular capital budgeting method, NPV allows you to select the most profitable projects and investments. Using the net present value method, you can select only one project or investment to invest in or you can choose several at once.

E) Internal rate of return (IRR)

By using the internal rate of return method, you can determine the percentage of return you can expect from a specific project. According to this method, the higher the rate of return percentage, the more appealing the project becomes. When a company has conflicting project options, it often uses the IRR method to decide which one to pursue.

F) Profitability index (PI)

One of the most important capital budgeting techniques is the profitability index (PI). The profit investment ratio (PIR) is also known as the benefit-cost ratio (BCR) and the value investment ratio (VIR). The index represents the relationship between investment and payoff of a project. It is mostly used for ranking projects. An investment is made according to the rank of the project.

Lastly,

I hope after going through this post you might have clearly understood the Question: An example of a capital budgeting decision is deciding whether or not to purchase a new machine for the production line.

Ending inventory is made up of the oldest purchases when a company uses

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Smirti

(Founder of Management Notes)
MBA,BBA.

I am Smirti Bam, an enthusiastic edu blogger with a passion for sharing insights into the dynamic world of business and management through this website.

I hold a MBA degree from Presidential Business School, Kathmandu, and a BBA degree with a specialization in Finance from Apex College,

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An example of a capital budgeting decision is deciding: