Capital Budgeting

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Week 4 Discussion Question 1b
Introduction
Capital budgeting is one of the most crucial decisions the financial manager of any firm is faced with...Over the years the need for relevant information has inspired several studies that can assist firms to make better decisions. These models are assigned so that they make the best allocation of resources. Early research shows that methods such as payback model was more widely used which is basically just determining the length of time required for the firm to recover the outlay of cash and the return the project will generate. Other models just basically employed the concept of the time value of money. We have seen that more current models are attempting to include their analysis factors that might significantly affect the decision made by the manager (Cooper et.al, 2001).
Recent studies have shown that capital budgeting decisions are highly important and most times complex. There are several reasons associated with the use of capital budgeting. First, capital expenditures require the firms to outlay large sums of funds to initialize the project... Second, firms need to formulate ways that will generate and repay these funds that were initially outlayed. Finally, having a good sense of timing , when using this model is also very critical when making financial decisions. Several alternatives models are commonly used when evaluating capital budgeting projects (Brealey, 1984): 1. The payback method 2. Accounting Rate of Return 3. Present Value 4. IRR (Internal Rate of Return) 5. MIRR (Modified Internal Rate of Return) 6. Real Options
Academics criticize both the payback and accounting rate of return models because they tend to ignore the actual size of the investment and how it was calculated by using the Time Value of Money (Cooper et al, 2001). Unlike the NPV model when this is used the firm discounts the projected income from the project at the hurdle rate. This rate is an acceptable rate



References: Brealey, R. and Myers. S . (1984), Principles of Corporate Finance. 3rd ed. New York: McGraw-Hill. Brown, K.(1978) “The Rate of Return of Selected Investment Projects,” Journal of Finance, Vol. 33 (4).pp.285-287 Cooper, W.,Morgan, R.& Redman,G. (2001) Capital budgeting models, theory versus practice [Online]. Available from: http://www.entrepreneur.com/article/116186585_3.html (accessed: 28 March 2009). Kim, Suk & Farragher, E. (1981) "Current Capital Budgeting Practices," Management Accounting ,pp. 26-30. Mao, J.(1970) “Survey of Capital Budgeting: Theory and Practice,” Journal of Finance, pp. 349-360

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