Question

Question 3

What types of project require the least detailed and most detailed analysis in the capital budgeting process?

Question 4

What is cost of capital and why it is important?

Answer 1

The level of Investment involved in a project dictates how much detailing is required. Higher investment results in greater level of risk assessment to secure better return from the project.

For example let's say A company wants to enter into a new market or wants to launch a new product. Here, detailed analysis of the Capital budgeting is required because to enter into a new market or to launch a new product, a huge advertisement cost is involved and where there is huge investment involved, there is huge risk. where there is huge risk, more detailing is required.

On the Contrary, expansion of existing product, of replacement project doesn't necessarily require more detailing as they can be decided by using simpler capital budgeting methods to evaluate such project and abide by the decision of the capital budgeting method.

Cost of Capital: - Any company that exist need funds to run its business. Funds can primarily be arranged from Bands or Institutions in the form of Debt or from Investors in the form of equity. Since these people are paying you money you money to run business, they expect some thing in return i.e. these funds have a cost.

So, the cost paid by the company to get these funds is called Cost of Capital.

Cost of Capital is Important: Estimating Cost of Capital is very crucial both for valuation purpose as well as decision making purpose. If a company needs to be valued then, we need an expected return of Debt holders and equity holders i.e. Cost of Capital. On the other hand Cost of Capital is also required for decision making. For example lets say that a company's expected return is 10% then, we are going to invest only if Cost of Capital is lower than 10%.