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5.2 Basic Principals governing Capital Budgeting Process
There are certain standard principals according to which the Capital Budgeting technique is applied and projects are evaluated. These are outlined below:
Cash flows vs. accounting profits- while evaluating projects the cash flows are considered, the cash flows which the project will generate in future. The accounting profits are not taken into consideration because it takes into account many items which are mere book entries and does not result in any actual cash inflow or outflow. Example: Depreciation expense. Similarly sunk costs are excluded while evaluating the project because these costs are already incurred and it won't have any bearing on the project.
Treatment of Opportunity Costs- while calculating the cash flows the opportunity costs must be taken into consideration. Opportunity costs are costs that the company forgoes by undertaking the project. For example if the firm has invested certain amount in a project, had the firm invested the same amount in a bank then it would have earned certain rate of interest. This interest amount is called as opportunity cost and must be deducted to calculate the earnings from the project.
Cash flows are calculated on an after tax basis, thus the impact of taxes are considered and cash flows are reduced accordingly.
Discounting- As the cash flows are generated in the coming years, so the timing is considered into consideration and the discounting of cash flows is done to get a more clearer picture as to how much will generate today if a specific amount is invested.
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