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Capital budgeting can be defined as the way to allocate resources of the firm in a most efficient manner which increases the value of the firm by highest magnitude. It is used to asses whether mine a firm’s long term investments such as machinery, replacement of machinery, new plants, new products, and research development projects are worth the funding through the firm’s capitalization structure. If they provide returns above required return then they shall be funded. Also capital budget determines how much to allocate between different expenses
Capital budgeting is not a scientific model, the methods adopted in capital budgeting have many limitations.
To minimize such problem , firm should use following methods to improvement
Rather than using old discounting method , we should use probability method of decision making.
The process by which a company evaluates possible big projects or investments is known as capital budgeting. Capital budgeting is not a scientific model, and the procedures used in it have numerous flaws.
– Forecast cash flow is incorrect because it is based on a set of cash flow assumptions rather than a thorough examination of the business situation.
– Time horizon: As the time horizon grows longer, the difficulty of forecasting becomes more difficult.
– Discounting rate: In general, budgeting uses a fixed discounting rate, which is taken into account as the firm’s cost of capital. The cost of capital may alter in response to changes in interest rates or other market conditions.
– Allocations of expenses. Many costs are sometimes overlooked while making decisions and are written off as sunk costs, which can cause problems with profit calculations.
To minimize such problem , firm should use following methods to improvement; In a discount, the interest rate for each year should be different.
We should utilize the probability approach of decision making instead of the previous discounting method.
Capital budgeting is the process that companies use to evaluate potential projects and investments. There are several methods that are used in the capital budgeting process, although some are more useful than others. These include the NPV method, internal rate of return method, profitability index, payback period, and discounted payback period. However, as with many evaluating tools in the finance world, some of these methods can be problematic. So it is important to know what kinds of problems we may run into when completing capital budgeting analysis. These problems include; cash flow, time horizon, time value, and discount rates.
Cash flows are the first and most important step in the capital budgeting process. However, they can be difficult to get accurate, as they are only estimates. If revenues are overestimated or costs underestimated then a project looking profitable may not be. Time horizon is a problem because the longer the time that a project covers, the more uncertainty there is in any estimates that we make. As many external factors that could occur in the future could affect cash flows. Such as inflation, wars, or competition from other businesses. Calculating the proper discount rate to use in any capital budgeting method that involves the time value of money can also be tricky, as there is always the possibility that external factors like increasing interest rates will occur, changing the cost of capital, and changing the proper discount rate. Time value is a problem to be aware of when using a method that does not account for the time value of money. The payback method is an example of this, as this method only asks how long it will take to recoup the initial costs of the project, without factoring in the time value concepts.
One solution that can be used to minimize the issues, is to never use just one capital budgeting method, instead many or all of these should be considered. Managers and decision-makers also need to be aware of external factors that may have an impact on calculations and adjust numbers as needed.
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