Question

1) Why is capital budgeting important to the firm’s future? Which method of evaluating projects is superior? Why?

Why do some investors prefer dividends and others prefer capital gains? Explain.

Answer 1

Importance of capital budgeting:

Capital budgeting decisions are of paramount importance in financial decision. The profitability of a business concern depends upon the level of investment made for long period. Moreover, the investments are made properly through evaluating the proposals by capital budgeting. So it needs special care

Involvement of large amount of funds in Capital Budgeting: Capital budgeting decisions need substantial amount of capital outlay. This underlines the need for thoughtful, wise and correct decisions as an incorrect decision would not only result in losses but also prevent the firm from earning profit from other investments which could not be undertaken.

Irreversible decisions in Capital Budgeting: Capital budgeting decisions in most of the cases are irreversible because it is difficult to find a market for such assets. The only way out will be scrap the capital assets so acquired and incur heavy losses.

Risk and uncertainty in Capital budgeting: Capital budgeting decision is surrounded by great number of uncertainties. Investment is present and investment is future. The future is uncertain and full of risks. Longer the period of project, greater may be the risk and uncertainty. The estimates about cost, revenues and profits may not come true.

Large and Heavy Investment: The proper planning of investments is necessary since all the proposals are requiring large and heavy investment. Most of the companies are taking decisions with great care because of finance as key factor.

Permanent Commitments of Funds: The investment made in the project results in the permanent commitment of funds. The greater risk is also involved because of permanent commitment of funds.

Long term Effect on Profitability: Capital expenditures have great impact on business profitability in the long run. If the expenditures are incurred only after preparing capital budget properly, there is a possibility of increasing profitability of the firm.

Maximize the worth of Equity Shareholders: The value of equity shareholders is increased by the acquisition of fixed assets through capital budgeting. A proper capital budget results in the optimum investment instead of over investment and under investment in fixed assets. The management chooses only most profitable capital project which can have much value. In this way, the capital budgeting maximize the worth of equity shareholders.

Superior method of evaluating projects:

NPV is considered the superior method.

NPV is considered a superior method of evaluating the cash flows from a project becauseit is able to rank projects of different sizes over varying periods of time to determine the most profitable course of action. A project with a NPV of $2,500 means that the wealth of the firm’s shareholders is expected to cumulatively increase by $2,500 if the project is accepted.

If a discount rate is not known, or cannot be applied to a specific project for whatever reason, the IRR is of limited value. In cases like this, the NPV method is superior. If a project's NPV is above zero, then it is considered to be financially worthwhile.

Sometimes there are at least two solutions for IRR that make the equation equal to zero, so there are multiple rates of return for the project that produce multiple IRRs. The advantage to using the NPV method here is that NPV can handle multiple discount rates without any problems. Each cash flow can be discounted separately from the others.

b)

Reasons for preferring dividends:

Investors like dividend stocks because it provides a source of income in addition to capital appreciation. If you invest in dividend aristocrats, you have a good chance of receiving your payout even during times when the stock price drops.

This provides you with a measure of stability (as long as you trust the company to keep paying a dividend) even in tough times. On top of that, when you add your income from dividends to the capital appreciation of the stock, your returns are more likely to beat the current savings rates. You can see a lot better potential return when you include dividends in the equation.

Plus, some investors like to reinvest their dividends. When you do this, the money that you receive in payouts is automatically used to buy more of the stock. This increases the number of shares you own without you needing to invest even more money. As a result of your increased shares, you will earn more in dividends at the next payout. It’s a cycle that repeats itself and can help you improve your ability to build wealth over time.

Reasons for preferring capital gains:

Dividends can increase transactions costs for other investors who are less interested in income and more interested in saving money for the long-term future

These long-term investors would want to reinvest their dividends, and this creates transactions costs

Although currently, dividends and capital gains are taxed at the same amount, starting in 2013, long-term capital gains will be taxed at lower rates than qualified dividends