Question

Capital Budgeting and Dividend Policy We examined two very important topics in finance this week; Capital Budgeting and Dividend Policy. Critically reflect on the importance of selecting the right projects in which to invest capital. Do we always select those projects that have the highest return on investment? What other factors play into capital budgeting decisions? We also looked at dividend policy. What incentive is there for a company to pay dividends? What signals does dividend policy provide to investors?

Answer 1

We'll divide the questions part by part and answer it...

Critically reflect on the importance of selecting the right projects in which to invest capital.

Business run upon the projects that render the returns which raise the earnings for every quarter/annual year. There can be number of opportunities of new projects or to improve the existing old projects. They can be exclusive or mutually exclusive in nature. Giving up on another project by choosing a different project over it can cause an Opportunity Cost. NPV and IRR are the tools which we use to arrive for a rating in between or among the projects. It's important to select a right project as to see which project is seeding a lot of capital and which gives us perfect ratio of risk with respect to the return over a period. After all, all these projects ultimately needs to give us a desired Return on Capital, and that is the reason why it's clearly important for the management to pick over a right project in order to sustain the business for future.

Do we always select those projects that have the highest return on investment?

Some project's are risky, some projects aren't. Some project's give highest return on time and some take longer time than expected. This may not give the business a ease of liquidity or may face a business risk even. So each project needs to be evaluated with the help of IRR or NPV and understand the cash flows whether acting as a benefit or not. So it's not always the ROI that plays an important role but also the risk, return and time involved comes into the selection priorities.

What other factors play into capital budgeting decisions?

Many factors play significantly in capital budgeting decisions such as the Cost of the Project, the risk in nature, the fixed and variable operating costs, the cash flows throughout the year,and the controls surrounded them.

What incentive is there for a company to pay dividends?

Here incentive could be a meaning of benefit provided to shareholders by offering them dividends. Dividends are the earned profit by the shareholders whereas company decides to declare the dividends in the times of profitable returns over the period. Benefit for the company is that the market value will be enhanced and more shareholders try to buy more stock which gives more money into the Equity Capital. This acts as a benefit to the company which pays off the dividends.

What signals does dividend policy provide to investors?

Dividends offered to the shareholders could bring the positive meaning that the stock is about to grow in the future where the shareholder's share value would be maximized. This gives the information that the company is running profits and it's time to cash in the deserved profit to the investors. Also talks about the company's performance being above expectations, company management making good decisions and good control and ownership displayed by the company management which wins shareholder's trust.