ACCA F2 - Management Accounting
Capital budgeting also known as investment appraisal involves decision making activities for capital/investment outlay (i.e. capital expenditure). It focuses on long time horizon. Activities for decision making in capital budgeting emphases primarily on budgeting cash flow statement and then to other financial statements. Cash is life blood of an organisation. A high initial cash outflow and lower value of inflow in subsequent period increases the likely risk and uncertainty in capital budgeting. Therefore, different tools are used to curb these problems.
Capital budgeting also known as investment appraisal involves decision making activities for capital/investment outlay (i.e. capital expenditure). It focuses on long time horizon. Activities for decision making in capital budgeting emphases primarily on budgeting cash flow statement and then to other financial statements. Cash is life blood of an organisation. A high initial cash outflow and lower value of inflow in subsequent period increases the likely risk and uncertainty in capital budgeting. Therefore, different tools are used to curb these problems.
Looking back in article "008 Cost Types", we know
how to classify cost in term of their relevancy for investment cost.
Relevancy cost - for investment appraisal
Ø
Irrelevant cost
o
Sunk cost - cost already incurred
o
Non cash flow costs
Ø
Relevant cost
o
Out of pocket cost - all direct and indirect
cost
o
Opportunity cost - earning opportunity forgone
when selecting one alternative project
Investment appraisal begins with cost and revenue
identification. The identified costs and revenues are processed using different
appraisal tools. Basic appraisal tools are NPV, IRR and Payback Period. They
only manipulate relevant costs.
NPV (Net present value): The differential value of all cash inflows
to cash outflows related to the project discounted at project's cost of
capital/(financing) is the net present value of the project. Any positive
residual amount indicates green signal for undertaking the project.
IRR (Internal rate of return): The discounting rate for
which total cash outflows and equates total cash inflows is internal rate of
return. Project with internal rate of return above cost of capital/(financing)
are viable for investment.
Payback Period: It indicates particular time in the life of
the project where initially invested outflows equates cumulative sum of inflows
generated by the project. Project with payback period earlier than the life of
project are acceptable for investment.
CPA Ireland Article: Capital Budgeting, Investment Appraisal and Business Decisions
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