Question

When we are studying capital budgeting, we go through a lot of work to come up with an investment decision. However, we have made many assumptions along the way to form what seems like a value-maximizing decision. Choose an assumption that we make and discuss the risks associated with that assumption.

Answer 1

Many a times, value-maximizing decisions under the capital budgeting process depends upon the quality of assumptions we make to evaluate the capital structure. Assumptions related to cash inflow and outflows changes the course of calculations required for indentifying the value-maximizing decisions.

Assumptions related to cash outflows, determining the initial investments as well as upcoming maintenance and operation costs whereas cash inflows assumptions determines expected future cash inflows and its expected value at the end of the project (terminal value).

The accuracy of these assumptions and reliability over these assumed values helps in assessing the value out of the capital budgeting process.

Another importance assumption is related to the fluctuating reinvestment rate. The NPV method implicitly assumes that cash flows over the life of the project can be reinvested at the firm’s required rate of return, whereas the IRR method implies that these cash flows could be reinvested at the IRR (Keown, Martin, Petty and Scott, 2002, p.282.)

Using various processes such as sensitivity analysis and monte carlo simulation, the risk under reinvestment rate can be judged. Thus standalone, market as well as corporate risks can be assessed under the value-maximizing approach of capital budgeting.