Question

• Define various capital investment rules and discuss any potential shortcomings and some of the difficulties related to each. Which one would be the easiest to implement in actual situations? The most difficult?
• Are the capital budgeting criteria appropriate for for-profit corporations are also applicable to non-for profit corporations? How should such entities make capital budgeting decisions? What about the US government? Should it evaluate spending proposals using these techniques?
• A financial manager at Amazon is quoted as saying, "At Amazon, we use a stand-alone principle. Since we treat projects like minifirms in our evaluation process, we include financing costs because they are relevant at the firm level." Critically evaluate this principle.
• What is forecasting risk? In general, would the degree of forecasting risk be greater for a new product or a cost-cutting proposal? Why?
• Why does traditional NPV analysis tend to underestimate the true value of a capital budgeting project?
• How important are statistics and computers simulations for determining the risk of a project?

Answer 1

Answer: Capital budgeting techniques- It is a set of techniques that are used to evaluate a project so that the same can be approved or rejected.

Capital budgeting techniques and their limitations- Are as following:

Discounted cash flow- In this methods, that figures out the future worth of the investment today, future cash flows are discounted with the help of present value factor to know the present worth. If the value of discounted cash flow is higher than the current investment then project is approved.

Limitation- Future cash flows are expected that are not actual, you cannot predict the future, you may get positive or negative cash flows.

NPV- Net present value is the capital budgeting technique to calculate the profitability of the project. In this method, present value of cash outflow is subtracted from present value of cash inflow and a positive NPV means the project should be approved.

Limitation- It is not good to guess the future expected cash fows and cost of capital. Sometimes these may be wrong based on extimations.

IRR- Internal rate of return is the rate at which net present value of all cash flow equals to zero. It expects the minimum return from a project.

Limitation- This method does not consider the project duration, size of the project and future cost.

ARR- Accounting rate of return is calculated by dividing the average net profit by average investment.

Limitation- This method considers only net profit, not the cash flows.

Payback period- This method is used to see in how many years (times) the initial cost will be covered.

Limitation- It does not consider the time value of money.

Easiest and simplest method- Payback period is the easiest to calculate and implement.

Difficult method- NPV is the difficult method, in this method, future value of cash inflows is difficult to estimate and sometimes it is not close to the actual results.