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Answer 1

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Capital budgeting is the method of analyzing and selecting long term investments which are in line with the goal of companies wealth maximization.

The capital budgeting decisions are important, vital and significant business decisions because

1.substantial expenditure involved.  

2. long period for the project.  

3. irreversibility of decisions.

4. The complexity involved in decision making.

The key inputs to the valuation process:

1. The expected cash flow from the assets over its lifetime and It's initial investment.

2. The timing of the cash flow.

3. The required rate of return from the cashflows to satisfy the cost of capital & risk levels.

Some common measures or techniques used in the capital budgeting process are:

1. Internal rate of return (IRR)

IRR: It is the discount rate at which the present value of projects cash outflows (cost) is equal to the present value of projects cash inflow.

The IRR must be above the cost of capital/required rate of return to accept the project.

In case of mutually exclusive project, The project with the highest internal rate of return given the first priority.

Pros: It provides the hurdle rate above which to accept the project.

Cons: IRR method reinvest the intermediate cash flow at IRR rate, which is not true and hence not a better technique.

2. Net present value.

NPV = present value of cash inflow- the present value of cash outflow.

Discounted at the cost of capital/required rate of return.

NPV must be positive to accept the project.

In case of mutually exclusive project, The project with the highest net present value is given the priority.

Pros: provide absolute dollar Returns.

Cons: less insightful in terms of profitability and interest rates.

3. Payback period: it is the amount of time required to recover the original cost of the project.

The project with the lowest payback period is given the first priority.

Pros: It simple to calculate and understand.

Cons: does not take the time value of money into consideration.

4. Profitability index= present value of cash inflow/ present value of cash outflow.

The project with the highest profitability index is given the first period in a ranking.

Pros: It an analysis of cash flow of the entire life.

Cons: It ignores the sunk cost.