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

As quoted in the question :

Quote :

"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."

Unquote

It is not known as to "what is learned thus far", however, it is assumed that various techniques and tools of capital budgeting and method of determining cost of capital are learned and well absorbed. By various capital budgeting tools, it is presumed to include, if not expert/pro level, but preliminary to medium level knowledge about concepts, calculations and applications of various capital budgeting tools such as Net Present Value (NPV), Internal Rate of Return (IRR), Discounted Cash Flows (DCF), Profitability Index(PI), Payback period and Discounted Payback period, Break-even analysis, Capitalized Cost of finite and infinite period projects, Accounting Rate of Return (ARR) and Real Options,

With above assumption, let us see why it is important to understand that capital budgeting is subject to the validity of forecasted data. It must be remembered that like all scientific and techical theories, financial theories or tools are based on certain assumptions. These assumptions are akin to laboratory conditions or core foundations on which these theories are based. When the laboratory conditions are properly set and met, scientific/technical theories give the desired results and are proven to be valid. Slight change of even a single laboratory condition leads to different set of results and leads to criticism & questioning of the theory. Similarly, for financial and accounting theories also as long as assumptions or foundations meet the reality, the results shall meet as envisaged under theory. But, reality is stranger than fiction and always different than assumptions. This where forecasted data may fail the validity and this could be most likely scenario.

e.g. In most of the capital budgeting tools, although we are reasonably accurate with respect to NOW and very near term variables & constants, we may be far away and on a tangent with respect to future expectations. We use a constant rate for discounting, its quite possible that this rate itself may be not correct or in sync with reality. Our forecasts of expected future cash flows may not be as accurate as we would like them to be. When we take a decision based on assumptions with the help of these tools, many of our decisions may need revisions due to internal and external factors which are either beyond our control or were unable to be foreseen or even if can be foreseen, their impact may be viewed as bordering on speculation and/or immeasurable.

The above discussion demonstrates the limitations of capital budgeting tools. It shows that these tools are not full proof or 100% accurate. But can one say that these reduces the reliability of these tools? In fact, it does not. These tools reduce the overall uncertainty and bring most of the variables within control and a tolerance limit when different tools are used together. These tools enable and focus the analyst/investor/management attention on core matters and put them in a position to adapt and respond to reality in a lot better and informed manner. Currently, these are the best available tools. In the past, these were most widely used historically with remarkable degree of success and the very reason being taught to next generation of finance managers. These are used even now-a-days with good results and variations of actuals from results arrived under these tools are, most of the time, well within the control of the management or party which uses these tools. This really underscores their importance.

For analysing capital budgeting in random environment and complex simulations, there could be much more highly complex designed models and/or derivatives of these tools (or otherwise) which are used to make algorithms and do sensitivity analysis by changing random variables. Yet, most of these are, basically, extensions and application of core ideas & concepts which make up these tools. So, there is no reason one can ignore and disregard/reject these tools summarily.