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 capital budgeting is subject to the validity of the forecasted data because capital budgeting is often assumed to be an objective method of determining viability of investments. However the forecast of data is based on certain assumptions and these assumptions are often subjective in nature. Thus it is important to understand that capital budgeting is subject to the validity of the forecasted data because capital budgeting is not always an objective assessment method as it is assumed to be. Some of the assumptions pertain to growth rate of cash flows, assumptions with regards to capital structure, and final growth rate that determines the terminal value. These do reduce the reliability of capital budgeting tools but not in a very significant manner. Even with these assumptions capital budgeting tools remain one of the most powerful methods to determine the viability of different projects and investments due to their theoretical soundness.

No, there are not many other sound alternatives available and we can say that these tools are some of the most reliable that currently exist. One has to ensure that the assumptions are made in a realistic manner and should be based on robust and valid points.