Question

Explain in detail why corporation engage in capital budgeting, present the pros and cons of the various methods and point out the selection criteria.

Answer 1

Capital budgeting is a process by which corporation take decision whether they should go ahead with a project or not. The decision to Invest in a project is based on cash inflow and outflow from that project. It helps the management in understanding risk and investment opportunities in a project. By analysing the cash flow and the timing of the cashflow, they are able to take better informed decision regarding that project. Capital budgeting process also gives the corporation to take into account the expenditure related to a project and maximize the shareholders wealth. Overall, capital budgeting is a very significant task undertaken by the senior management for the long term sustainable growth of the company.

Pros and cons of various capital budgeting methods and selection criteria:

Technique Pros Cons Selection criteria Payback period It is very simple to It does not considers calculate and very easy the cash flow in the to interpret for any one. later period. It does not It provides a times provide any information period in which your about the risk and also investment will be ignores time value of recovered. money The best part of this It requires the method is it considers assumption and the time value of money calculation of rate of and risk of the project is return which can considered through the significantly affect the required rate of return value. Discounted cash flow Net present value It discounts the cash flow and tells whether this project is going to increase the value. It does considers the time value of money It also requires an estimate of cost of capital which is a significant issue. This method is suitable for short term project where the cash flow is occurring at the beginning of the project life and no cash flow at later stage. This method is more appropriate for long term heavy capital expenditure where the required rate of return and time value of money is of significance. This method can be used for long term as well as short term projects where the cash flow are occurring at different time period. In real world NPV is more frequently used. IRR is a simple method that is used by companies to figure out at what rate of return NPV becomes zero and then to compare it with the cost of capital. IRR (Internal rate of return) It is simple to calculate and it considers all the cash flows. It tell whether a project should be accepted or not. It does considers the time value of money. it might give more than one IRR when the cash flows from the projects are non-conventional. It also requires cost of capital decision with the IRR to take the decision. This may not give value maximization decision