Question

1. What is capital budgeting? Are there any similarities between a firm’s capital budgeting decisions and an individual’s investment decisions?

Answer 1

Capital budgeting:

Capital budgeting is defined as the process of analyzing the additions to the firm’s fixed assets. It is considered to be very important because they chart the investment decisions relating to fixed assets of the company’s future course. The capital budgeting decisions of the firm are very much similar to the investment decisions of the individual. These are the steps that are involved:

• Estimating the cash flows: interest & maturity value or dividends for stocks & bonds & for capital projects it is the operating cash flows.
• The next step would be to assess the risks involved in the cash flows.
• The next step is to determine the appropriate discount rate which is based on the riskiness of the cash flows & the level of interest rates. This is called as project cost of capital in capital budgeting.
• The fourth step is to find the PV of the expected cash flows or the rate of return on the assets.
• If the PV of inflows is greater than PV of outflows, the npv is positive or if the irr is greater than the cost of capital of the project, it is better to accept the project.