Question

“Capital Budgeting is the formal process of investments or expenditure that is huge in amount. It involves the company’s major decision where to invest the current fund in the development of the organization such as for addition, disposition, modification or replacement of fixed assets. Capital budgeting becomes important due to the huge amount of investment that is involved and the risk associated with the same”

1. (a) Required to critique the above statement by evaluating and providing importance of capital budgeting.

(b) Based on above provide local examples in places where possible. Specifically, explain which capital budgeting method would you prefer while deciding on fixed long-term investments.

Answer 1

For companies, long-term investments represent significant cash outflows. For this reason, companies need procedures to analyze and select long-term investments. Capital budgeting is the process of evaluating and selecting long-term investments, which must be consistent with the goal of maximizing the wealth of the owners of the company. Among the long-term investments,the most common are those related to investments in property, plant and equipment. These assets are normally know as productivo assets, and generally lay the foundation for the ability to gain strength and value un companies.

Now, any management decision consists in making decisions for the future and any future event can only be predicted in terms of mere approximations. The farther the horizon is from the event, the approximation will be the more imprecise. In the case of physical investments, whose future income may extend to time horizons of 5,10 or more years, this circumstance becomes more relevant. At the time of making an investment, your future profitability depends on thefuture sales of the products generated by that investments, sales that will take place over several years. Sales for next month, or even next spring, are not exactly known but some estimates can be made.

Capital budgeting methods

Companies are constantly evaluating ideas for new investments. To ensure that selected investment projects have the best opportunity to increase business value, managers responsible for finances need tools to help them assess the benefits of individual projects and rank the investments that are best for them. Preferred methods are those involving time-worth procedures, risk and perfomance aspects. Among the best known are:

1. Investment payback period

2. Net Present Value (NPV)

3. Internal Rate of Return (IRR)

These 3 know methods consider the evaluation of investments in the long-term under the environment of certainty. In this order of ideas, it is worth mentioning as methods that consider uncertainty the evaluation of scenarios, sensitivity analysis and the Monte Carlo method