Capital Budgeting: Advantages and Limitations

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CAPITAL BUDGETING: ADVANTAGES AND LIMITATIONS.

SEPTEMBER 2012

CHAPTER ONE
INTRODUCTION
1.0 Background Study
Capital budgeting is the process by which firms determine how to invest their capital. Included in this process are the decisions to invest in new projects, reassess the amount of capital already invested in existing projects, allocate and ration capital across divisions, and acquire other firms. In essence, the capital budgeting process defines the set and size of a firm’s real assets, which in turn generate the cash flows that ultimately determine its profitability, value and viability. In principle, a firm’s decision to invest in a new project should be made according to whether the project increases the wealth of the firm’s shareholders. For example, the Net Present Value (NPV) rule specifies an objective process by which firms can assess the value that new capital investments are expected to create. As Graham and Harvey (2001) document this rule has steadily gained in popularity since Dean (1951) formally introduced it, but its widespread use has not eliminated the human element in capital budgeting. Because the estimation of a project’s future cash flows and the rate at which they should be discounted is still a relatively subjective process, the behavioural traits of managers still affect this process. Capital budgeting is a process that is used to determine whether or not certain projects are worthwhile investments. Another term for capital budgeting is called an “investment appraisal.” Every firm has both a limited amount of capital available and a desire to deploy that capital in the most effective way possible. When a firm is looking at, for example, acquisitions of other firms, development of new lines of business or major purchases of plants and equipment, capital budgeting is the method used to determine whether one option is better than another. Although conceptually capital budgeting is simple to understand, creating a capital budget has some definite challenges. Accounting for costs, benefits and projected profits can be difficult simply because certain aspects of the investment deal weigh more heavily on the decision to make that investment deal than others. Most benefits in capital budgeting can be classified in two ways. First, is to create one category for benefits that affects levels on the profit and loss statement directly. Secondly, specify benefits that may not be as easily measured on a statement of profit and loss. Net Present Value (NPV), Payback Period, Internal Rate of Return (IRR), Accounting Rate of Return(ARR) and Real Options Approach are some of the methods used in capital budgeting and each method has its own advantages and disadvantages. 1.1 Problem Statement

The capital budgeting decision has been a very a typical issue in the sustenance of a firm. Several firms have lost their identities or liquidated due to wrong capital budgeting decision they made at one particular point in time or the other. Based on these prevalent problems in firms and the effect of globalization on firms, it is important to use effective method to analyse investment before decision is made. Capital budgeting is extremely important because the decision made involves the direction and opportunity for future growth of every firm. This study seeks to examine the advantages and limitations of capital budgeting.

1.2 Objectives of the Study
This study therefore seeks to investigate and analyze the following objectives for the purpose of serving as reference to firms and policy makers. * To identify the methods used in capital budgeting.

* To identify and examine the advantages of capital budgeting. * To identify and examine the limitations of capital budgeting. 1.3 Significance of the Study
The finance function has to deal with one of the most important...
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