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 .:

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Answer 1

Capital budgeting is the process of evaluating and selecting longterm investments that are consistent with the firm’s goal of maximizing owners' wealth. Capital budgeting involves choosing among various capital projects to find the one(s) that will maximize the return on the capital invested.
The important points are: − Capital budgeting is the most significant financial activity of the firm. − Capital budgeting determines the core activities of the firm over a long-term future. − Capital budgeting decisions must be made carefully and rationally. − Long-term investments may be in the form of a new project, or to expand an existing firm, or to acquire a new fixed asset. In all cases, the capital budgeting decision is related to the future thus it may contain many uncertainties. − Capital budgeting emphasizes the firm’s goal of wealth maximization, which is expressed as maximizing an investment’s Net Present Value.
Many companies follow a carefully prescribed process in capital budgeting. At least once a year, proposals for new projects are requested from each department and plant. The proposals are screened by a capital budgeting committee, which submits its findings to the officers of the company. The officers, in turn, select the projects they believe to be most worthy of funding and submit them to the board of directors. The directors approve the investment decision for the next period. The involvement of top management and the board of directors in the process demonstrate the importance of capital budgeting decisions. These decisions often have a significant impact on the future returns.
Capital budgeting involves:
− Committing significant resources
− Planning for the long term: 5 to 50 years.
− Decision making by senior management.
− Forecasting long term cash flows.
− Estimating long term discount rates.
− Analyzing risks.
− Calculating a project’s relevant cash flows
Capital budgeting uses:
− Sophisticated forecasting techniques.
− Time series analysis by the application of simple and multiple regression, and moving averages
− Qualitative forecasting by the application of various techniques, such as the Delphi method
− Application of time value of money formulae
− Application of Net Present Value (NPV) analysis to forecasted cash flows
− Application of Sensitivity and Break Even analyses to analyze risk
− Application of Simulation and Monte Carlo Analysis as extra risk analysis
− Application of long term forecasting and risk analysis to projects with very long lives.