Question

In considering what we have learned thus far regarding the importance of determining the cost of capital as well using capital budgeting tools, explain why it is important to understand that capital budgeting is subject to the validity of the forecasted data. Additionally, explain whether this reduces the reliability of these types of tools. Are there any other alternatives, or are these tools some of the most reliable that currently exist?

Answer 1

It is Important to understand that the decision being taken on the basis of capital budgeting method are not free from bias or error. The decision being taken on the basis of capital budgeting method and outcome of that decision, they are going to be favorable or not depends on the input data. The input data in the calculation of NPV or IRR like cash flow estimation, discount rate estimation are subject to bias.These data estimation can vary from Individual to Individual depending on the risk metric of that Individual towards that project. So capital budgeting tools are not free from errors. If the input data is precise then the decision being taken would result in more favorable outcome but if the input data is far from the actual value, the decision taken can also be wrong.

The future is uncertain, no matter how much effort you make you can not predict the future events precisely. This certainly does not diminish the usefulness of the capital budgeting method because some way or the other way you are going to use them in your decision. As long as the input data is with in the range of deviation, it is ok but deviating too much from the expected value can be disastrous.

The other alternative with reference to the main capital budgeting methods like NPV, IRR are scenario analysis, estimatig the probability of cash flow under different scenario. Scenario analysis gives the management a broad idea that the what kind of performance can be expected from the project being reviewed under different scenarios. Similarly, under projecting cash flow with different probability gives an expected value which might be better than directly forecasting cashflow for time periods.