Question

Why you would make an investment if the value of the expected cash flows exceeds the cost of the project ?Why are capital budgeting decisions among the most important decisions in the life of a firm? Why profit maximization is not the best goal for a company. What is a better goal?

Answer 1

One will make an investment if the net present value (NPV) of the investment is positive where, NPV compares the value of a dollar today of a project to the value of that same dollar in the future. NPV is used in capital budgeting method to measure the profitability of a project. The project will be profitable only if the value of the expected cash flows exceeds the cost of the project.

Net present value (NPV) of project = [Expected cash inflow/ (1+ Discount rate) ^n] – Initial cost of project

Where,

Time period n = 0, 1, 2, 3……… n

Initial cost of project is the cash outflow at year 0

Expected cash inflows are CF1, CF2, CF3 ….CFn at time 1, 2, 3 …n respectably

Capital budgeting is the process of identifying, evaluating and taking decisions on the long term investments plan of the company. During this process, company evaluate various alternatives of investment in different projects and select one of the best alternative based on its cost, rate of return, NPV, time required and risk associated with it etc. once the decision is taken and investments are made then it’s not easy to revert it back, therefore the capital budgeting decisions is among the most important decisions in the life of a firm.

Profit maximization is not the best goal for a company because it is relatively for short term. The value maximization of the corporation is the best for the long-term benefits of the company. The primary goal of a corporation is the maximize shareholder’s wealth and value creation. A firm’s value can be maximized if its expected benefits are maximized in the long-run.