Question

Provide a discussion of the capital budgeting process and how this process supports the allocation and use of this scarce resource. Discuss how we use NPV, IRR and Payback period as tools in this process and the decisions that can follow therefrom.

Answer 1

Capital budgeting decisions are made in order to find out whether to invest in certain projects or not, based upon the risk exposure and return associated with the same project.

capital budgeting advocates that financial capital is scarce and limited to the firm. Like any limited resource, financial capital have a price and it must be properly allocated by the firm to maximize the return in order to pay the cost of these financial capital,so it should be only are located into such resources which will yield the benefit to the firm because financial capitals are scarce in nature, they are not abundant.

Net present value is used to analyse whether to accept the project or not. Only such projects are accepted whose net present value is positive.

Internal rate of return is used to identify whether to accept the project or not. If internal rate of return is greater than hurdle rate , only then, project is to be accepted.

Under the payback period method, if the project is long enough and it is quickly giving the payback of the entire investment then, project is to be accepted if payback period is greater than 1.