Question

Identify four reasons that capital budgeting decisions by managers are risky.

2.     Why is an investment more attractive to management if it has a shorter payback period?

3.     Why should managers set the required rate of return higher than the rate at which money can be borrowed when making a typical capital budgeting decision?

4.     Why does the use of the accelerated depreciation method (instead of straight line) for income tax reporting increase an investment’s value?

After you’ve completed the questions above, please provide a brief explanation of how this information is important in managerial decision making.

Answer 1

1) Capital budgeting is the process in which organisation determines and evaluates long term investments. These decisions are risky because of four reasons,

A) Uncertainty and risk

B) Large sum of money is involved which if lost can be a huge setback.

C) Long commitment is needed.

D) Uncertain cost of raising capital in future.

2)

An investment project is accepted or rejected on the basis of payback period. Payback period means the period of time that a project requires to recover the money invested in it. The payback period of a project is expressed in years and is computed using the following formula:

Formula of payback period:

According to this method, the project that promises a quick recovery of initial investment is considered desirable. If the payback period of a project computed by the above formula is shorter than or equal to the management’s maximum desired payback period, the project is accepted otherwise it is rejected.

3) The required rate of return is the minimum return an investor will accept for owning a company's stock, as compensation for a given level of risk associated with holding the stock. The RRR is also used in corporate finance to analyze the profitability of potential investment projects.The required rate of return is also known as the hurdle rate, which like RRR, denotes the appropriate compensation needed for the level of risk present. Riskier projects usually have higher hurdle rates or RRRs than those that are less risky.

4) Accelerated depreciation is any method of depreciation used for accounting or income tax purposes that allows greater deductions in the earlier years of the life of an asset. While the straight-line depreciation method spreads the cost evenly over the life of an asset, an accelerated depreciation method allows the deduction of higher expenses in the first years after purchase and lower expenses as the depreciated item ages.The use of accelerated depreciation methods are mostly logistical. Although an asset is not required to be depreciated in the same manner in which it is used, an accelerated depreciation method tends to make this occur. This is because an asset is most heavily used when it is new, functional, and most efficient. Because this tends to occur at the beginning of the asset’s life, the rationale behind an accelerated method of depreciation is that it appropriately matches how the underlying asset is used. As an asset ages, it is not used as heavily, since it is slowly phased out for newer assets.

These decisions are considered as important because it helps the management in proper planning of investments and rates of return in order to take decisions.