The Importance of Capital Budgeting

CONTENT

INTRODUCTION

Capital budgeting is one of the primary activities of a company. Most of the company uses capital budgeting for decision making process of selecting and evaluating long-term investment. The company have to make a right decision with respect to investment in fixed asset such as purchasing of new equipment and delivery vehicles, constructing additions to buildings and many more. The decision must be right because of the project involve huge amount of cash outflow and it is committed for many years.

Most of the companies use capital budgeting as a tool for maximizing their future profits since they are able to manage only a few number of large projects at any one time. Below are several methods that are used in capital budgeting such as:

• Accounting Rate of Return

• Payback Period

• Net Present Value

• Profitability Index

• Internal Rate of Return

• Modified Internal Rate of Return

• Equivalent Annuity

• Real Options Valuation

QUESTIONS

a) The evidence of many recent studies suggest that there are major differences between current theories of investment appraisal and the methods which firms actually use in evaluating long-term investment.

i) Present theoretical arguments for the choice of net present value as the best method of investment appraisal;

ii) Explain why in practise other methods of evaluating investment projects have proved to be more popular with decision-makers than the net present value method. (Please compare at least three (3) methods)

b) Describe the process a company may use in screening and approving the capital expenditure budget.

c) For decision making purposes, the projects can be further divided into two groups which is independent project and mutually...

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...ject which the selection of any project eliminates the possibility of selecting another project. In mutually exclusive projects, all projects are to accomplish the same task. Therefore, the company only can select one project. Project is accepted depends on the different factors like initial investment, time period required for completion, strategic importance of the project and so on. For example, there are three projects; Project A, Project B and Project C. The company select Project C. The selection of Project C means that Project A and B are automatically rejected. All replacement projects of existing project are mutually exclusive. Examples of mutually exclusive projects include projects that need or use the same type of capital investment, like consumption of a common raw material. Normally, the project which adds more value to the business will be selected.