Question

“Capital budgeting is the process of evaluating and selecting long-term investments that are consistent with the firm’s goal of maximizing owner wealth”. Critically examine this statement.

Answer 1

Capital Budgeting is a process to understand and evaluate the various possible options of long term / strategic investments with the ultimate goal to meet the firm's objectives of increasing the shareholders value.

Evaluation of these investment options are very critical and need to consider many factors like cost of capital, return on investment, time value of the expected cash flows, any opportunity losses or gains, inflationary trends and impact, etc;

Over the period, various techniques have been evolved to study the investment projects and to test the feasibility of the same.

Capital Budgeting Techniques:

For any Project / Major CAPEX evaluations, the three most common capital budgeting approaches are Payback period, Internal rate of return (IRR) and Net Present Value (NPV).

The payback period determines how long it would take a company to see enough in cash flows to recover the original investment.

The internal rate of return (IRR) calculates the percentage rate of return at which those same cash flows will result in a net present value of zero. It used to determine the attractiveness of the Project.

The Net Present Value (NPV) results in the total net cash inflows expected from a project at the present value using a discounting factor. This is used to quantify the reseults in value terms from the entire project, covering all the cashfows from the project.

While most of the times NPV and IRR result in the same outcome on the feasibililty of the Project, there shall be cases of conflicting opinions as well;

Incase of analysis of a single conventional project, both NPV and IRR might provide same indicator on the evaluation of the project or not. However, while comparing two projects, the NPV and IRR may provide conflicting results.

Also, incase of mutiple cash flows trends (positive, negative, positive, negative etc) during the Proejct period, the IRR fails to provide answer and in this case NPV shall be useful as it covers all the cashflows - either Positive or Negative.

Hence, these need to be considered as evaluation tools and the final judgement shall be taken based on various other aspects as well; A project with lower IRR, however, more longevity might be more beneficial for an entity with a project with higher IRR with shorter life span; Many factors contribute the overall evaluation.

Other appraoches include Profitability Index, MIRR%, etc;