Question

Given the stakes involved and the uncertainty associated with the process, is it worthwhile to undergo such a capital budgeting exercise? What do you believe are the advantages and disadvantages of the capital budgeting process? What are some of the things managers can do if they realize that the project they have undertaken is not turning out the way they envisioned during the capital budgeting analyses? Presumably, as the time horizon becomes longer, the harder it becomes to predict the cash flows associated with the project. However, most ambitious projects would require long-term planning. How can a manager reconcile these conflicting and challenging issues?

Answer 1

Why it is worthwhile to undergo capital budgeting exercise –

When stakes are involved and there is uncertainty associated with the process, it is important to consider all factors involved in situation to make final decision. Taking decision becomes easy when numbers are involved. So in capital budgeting, there are different techniques to convert risk & uncertainty into numbers.

Here are some of the techniques which can handle the risk factor of capital budgeting:- 1. Risk-Adjusted Discount Rate 2.Certainty-Equivalent 3.Quantitative Techniques 4. Probability Assignment 5. Standard Deviation 6. Co-Efficient of Variation 7. Sensitivity Analysis 8. Decision Trees.

Advantages of capital budgeting -

§ Understanding risks & its effects

§ Decision making in investment opportunities

§ Adequate control over expenditure

§ Abstains from over or under investing

§ Using various techniques of capital budgeting

Disadvantages of capital budgeting -

§ Decisions are for long-term and are majorly irreversible in nature.

§ Techniques are assumed & not real

§ Uncertainty leads to wrong applicability

§ Availability of skilled professionals is not easy

§ Expensive.

§ A wrong decision taken can affect the long-term durability of the company

§ Professionals who understand the project well are required

What managers can do if they realize the project is not turning out the way as per capital budgeting analyses –

Managers need to see the reasons why the project is not turning as per the analysis. Capital budgeting involves many assumptions and forecasting. So it required to evaluate what assumption or forecasting went wrong. Re-evaluate the project and calculate the profitability of project.

Reconciling conflicting and challenging issues –

It is true that most ambitious projects require long term planning and requires predicting future cash flows. The main objective of capital budgeting is to consider various factors involved in decision making. Time value of money is the most important concept which is considered in capital budgeting.

One of the keys to creating accurate cash flow forecasts is having historical data about revenues and expenses. Cash flow projections are not set in stone. Revisit your projection from time to time to see where you stand.

If you see major differences or flaws in your cash flow forecast, it may be time to crunch more numbers and do some digging. Pinpointing issues with your projection early on can prevent major inaccuracies in the future.