Question

Briefly explain the importance of the capital budgeting. Then, explain the pitfalls (if any) of capital budgeting and describe how each pitfall influences the decision to accept or reject an investment. Support your post with specific references to each type of capital budgeting: net present value, internal rate of return, and payback.

Answer 1

Capital Budgeting

Capital Budgeting is a process to evaluate and measure the possible outcomes of large investments for example – buying a new machine or build a new plant, new R&D project. Companies do capital budgeting to understand the risk and return involved in undertaking a big project. Also, they are viewed as a responsible company by the investors for performing capital budgeting. Also, it is done when a company is faced to two or more choices of projects to undertake in the coming future to know which project is going to generate a higher return. There are mostly three ways in which companies perform capital budgeting – Payback period, NPV method, IRR method.

Importance of Capital Budgeting

[NPV Rule] - Any project with a positive NPV means that the project is going to increase the value of the firm. [Payback Rule] - Similarly, payback rule states that a project can be accepted if it’s payback period is less than or equal to some specific cut-off period. [IRR Rule] - The third method which is based on the internal rate of return or IRR is the rate at which the NPV of the project is zero. Now if the project’s opportunity cost of capital is less than its IRR, the project can be accepted. However, NPV is always preferred over other methods because a project’s aim is to increase the value of the business and investors and NPV methods clearly talks about the value added to the firm by undertaking a particular project. Some of the importance of capital budgeting are mentioned below:

- Through capital budgeting companies are able to plan and formulate strategies for the future growth of the companies. Hence, capital budgeting help in formulating long term strategies for the firm.

- If a company evaluates the risk and returns of various projects through payback, NPV or IRR method, the company is at a better position to look for new investment projects in order to maintain their growth and stay ahead of their competitors in business.

- Capital budgeting also helps in forecasting the future cash flows and these cash flows create value for the investors and the business overall. Hence, capital budgeting can be helpful in attracting investors as well. NPV method is based on forecasted cash flows from the project and the opportunity cost of capital.

- Finally, capital budgeting is very important because it helps in decision making by providing relevant information to the decision makers. Hence, different projects are accepted or rejected based on the results of capital budgeting.