Question

Brief explanation of theory of capital budgeting and some of the techniques used.

Answer 1

Capital budgeting theory is a method used to evaluate investment projects and choose projects that maximize shareholder wealth. It is a quantative technique of assessing a capital investment and determine if the long term projects are viable.Stages in capital budgeting include:

1. Screening the investment and selection

2. A proposal for the capital budget is prepared.

3. The bugdets are approved and authorized.

4. Once the project is approved, work begins and firms periodically address the progress for cost over runs or the need for marketing research.

5. Post completion audits are done to see if they are to be continued and if the actual cash flows match with the forecasted cash flows.

Techniques used:

1. The first criterion for evaluation is the hurdle rate. It is the rate that which the future cash flows from the project when discounted must exhibit a positive cash flow. The capital investment must generate a profit that exceeds its hurdle rate.

2. The second criteria is the payback period to judge how much time will pass before the company recovers its investment. A project with a lower payback period is prefered to a one with a longer payback period.

3. Net present value is the third criterion to evaluate the project. NPV is the value of the discounted cash flows usign an appropriate discounting rate. A positive net present value i.e. the excess of discounted cash flows over the initial investment must be accepted and a project with negative NPV is to be rejected.

4. The fourth technique is Internal rate of return. It is the discount rate at which the NPV of a particular project is zero. IRR must be used in conjuction with NPV and it usually favours those with largest rate of return.