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In this short essay, the author presents an analysis of the Capital Budgeting and its challenges. The author has further discussed the practical problems associated in cash flow estimation and the recommended methodology to deal with these problems. In the end the author presented some discussion points.
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Download file to see previous pages pp2-3) in which the project is either accepted or rejected based on its value addition to the firm and the shareholder wealth. The author showed that the cost of capital of a project is marginalized to maximize the shareholder wealth by including rate of interest, the required rate of return to stock holders, corporate marginal income tax rate, debt to equity ratio and lifetime of the proposed project and the weighted average cost of capital. In a paper written by the same author later (Beranek. 1980. pp404-405) claimed that the Net Present Value rankings of the investment opportunities do not match equity market value unless the projects are of one period duration or are solely equity financed. He established the widely used criteria of accepting a project only if its Present Value is greater than zero and recommended that the project among multiple Mutually Exclusive projects having highest Present Value should be chosen. However, Beranek (1975. pp17) warned of some practical challenges in implementing this technique in capital budgeting due to uneven cash flows, non-straight line income tax & other depreciations, varying methods of repaying the debts, different treatment of shareholders between capital gains & dividends, errors in calculation of weighted average cost of capital in finite lived projects, etc.
His fears were not unreasonable in those years given the current sophistication of capital budgeting procedures that takes into account complex metrics like risk analysis (both systematic & non-systematic), computerized simulations & stress tests, inflation, etc. In fact Pike (1984. pp95) carried out a broad level research on relationship between sophistication of capital budgeting and firm performance to conclude that higher sophistication of capital budgeting impacts firm performance negatively.
Overall, Net Present Value has remained the most trusted method to evaluate capital budgeting decisions due to its shear advantage of evolving the "time value of money". Majority of expansions, new operations or replacement decisions are based on NPV technique (Sun & Queyranne. 2002. pp528). Although NPV has some pitfalls especially when the inputs to the NPV calculations (like interest rates, risk perceptions, etc.) vary considerably, it is the most effective technique to evaluate the true value of capital budget when evaluating the returns from a project. It may however not give a complete picture of returns from an accepted project and hence the Internal Rate of Return (IRR) technique should be used along with the NPV technique.
Cash Flow Estimation under Capital Budgeting - Issues and Resolutions
Most of the analysts associate larger risks with projects that are of longer durations. This is because the speculations of risks, interest rates, inflation, etc. become more unpredictable for longer durations. The NPV technique is perfect for a single duration project but if the inputs vary too much (like interest rates vary considerably within a short span of time), the project can no-longer be treated as single duration. Beranek (1980. pp404) presented an empirical ...Download file to see next pagesRead More
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