Question

You are the chief financial officer (CFO) for an organization and need to discuss with fellow C-suite executives that cost cutting is not the only answer to profitability. Prepare for the next manager's meeting by responding to the following prompts:

·Explain how a capital budget and a return on investment contribute to sustainable growth.

·Clarify the role that risk analysis plays during capital investment decision making.

Answer 1

Explain how a capital budget and a return on investment contribute to sustainable growth.

Capital budgeting is the process of determining whether a potential investment is worth undertaking or not. It takes into account the potential cash flows and rate of return to determine whether the project will be profitable or not. Thus, a prudent and correctly-done capital budgeting process ensures that the approved projects/investments will generate more returns than required to cover the cost of capital. Moreover, diligent analysis of the expected return on investment from the project or investment, one can ensure that the amount earned from the investment is more than the amount invested. Hence, it creates wealth for the investor. Thus, we can see that a focus on proper capital budgeting and sufficient return on investment can ensure that the investment is made only on those projects/investments which can provide a sustainable growth.

Clarify the role that risk analysis plays during capital investment decision making.

Risk analysis is critical to ensure a proper capital budgeting process. The Cost of capital has to take into account certain risks such as interest -rate risk, etc. which can increase expenses in future and impact return on investment. Other risks such as any industry-specific risk, foreign exchange risk (if applicable), any project/investment-specific risk, or market risk. All these risks can be factored in while performing the capital budgeting process so that the decision maker is aware of the potential impact on return on investment in future under various scenarios. Hence, risk analysis is most important in the context of long-term investment decision-making measures.