Question

How does Capital Budgeting assist managers in decision making? Define the process to arrive at a decision following analysis of capital budgeting alternatives. Provide an example of capital budgeting you have encountered in your career or have read about.

Answer 1

Capital budgeting decision means allocation of the capital on the basis of profitability and return generation capacity of various projects.it advocates that capital should only be allocated to those projects which will be generating a positive rate of return to the company and it should be beneficial for adding value to the company.

Capital budgeting decisions assist managers because it has a combination of various kinds of tools which helped in decision making while using various kinds of sophisticated tools like net present value, internal rate of return, discounted payback method etc

These methods help in making decisions regarding various projects about their profitability in the future and the suitability and risk exposure in relation to the organisation and then the organisation select the best project which suits its risk profile and return profile and incorporate it within the strategy, so capital budgeting decision is highly important because capital has to be allocated to various different projects for longer period of time and these capital are mostly long term capital in nature so capital budgeting decision helps in making efficient decision regarding allocation of the capital to best projects.

While following net present value, if there is a positive net present value then the project is to be accepted, if there is a negative net present value the project is to be rejected.

If there is a higher internal rate of return than weighted average cost of capital, then project should be accepted, if there is a lower internal rate of return than Weighted cost of capital than projects will be rejected.

Whilw calculation through discounted payback method only such products will be selected which have a discounting payback period or lower duration and profitability index of higher than one.

I had to select through two mutually exclusive projects while taking a decision regarding allocation of the capital and I use present value and internal rate of return in combination in order to decide which one of them is to be selected because one method can be sometimes contrasting in nature to the other.