Question

1. Discuss how the capital budgeting concept is used to determine how a new project (hiring a management employee or investing in a new product/service) is worthwhile. Explain in detailed with examples and explanation for atleast 3-4 paragraph.

Answer 1

Capital budgeting- It is a technique to analyze a project so that approval or rejection decision can be taken regarding a particular project. It evaluates potential projects with the help of Capital budgeting methods and chooses the best alternative that provides positive and higher cash flows in the futures.

Investment decisions can be taken lightly, they require proper research, evaluation and analysis. Capital budgeting helps in doing the same.

Methods of Capital budgeting- Are as following:

Net present value- In this method present value of future cash inflows is calculated and compare to the initial investment, if present value of future cash inflows is greater than the initial investment, project is approved otherwise not. This method takes time value of money into consideration.

Internal rate of return- This is the rate at which net present value of an investment is zero. Discounted cash inflows are equal to discounted cash outflow.  

Payback period- This method calculates the number of years, it will take to recover the initial investment. Lower payback period states that project should be approved, longer period is not good.

Importance of Capital budgeting in project decision- Few points are as following:

1. It calculates and analyzes the project worth, with the help of future cash flows and compare the same with the initial outlay, so that profitability of a project can be know and the best alternative can be chosen among the available alternatives.
2. Capital budgeting helps management to take big decisions that involve a heavy investment.
3. It also helps management to understand the importance of opportunity cost.
4. Capital budgeting creates accountability and analyzes risk and return of a particular project.
5. It also tells the importance of Time value of money.