Part I: Theory1. Research the topic of capital budgeting in general, and explain what it is, and why it is used. Capital Budgeting is the planning process used to determine whether a firm’s long term investments such as new plant, new machinery, new product etc. are worth pursuing or not. It is the process of selecting the best long term investment proposal which yield the most return over an applicable period of time. In other words, it is investment decision-making as to whether a project is worth undertaking. It is basically concerned with justification of capital expenditure. Its decisions are not equally essential and similar to all companies as its importance varies from company size, type of business, nature of industry and the growth rate of the firm.
It is also “Investment Appraisal”. Why Capital Budgeting is used? Capital Budgeting is an important managerial tool. A firm has limited resources whether we consider its capital or assets which have some value in terms of money. Faced with limited resources, management of the firm has to decide about their best long term investment alternative which is economically acceptable and have high returns during an applicable period of time.
Management of the firm can follow a sound procedure called Capital Budgeting to evaluate, compare and select from the set of alternatives. It helps to estimate the cash flow, access the cash flow risks, and determine appropriate discount rates, payback values etc. In other words, Capital is the main resource for a firm and Capital Expenditure has very large and significant impact on the financial performance of the firm, so the management has to take proper decisions before any investment and Capital Budgeting is the tool provided to them. 2.
Define the time value of money and explain why it is necessary to consider this when making investment decisions. Time value of money is the value of money with the given amount of interest earned over a given amount of time. In simple words, it is a concept which addresses the ways of changes in the value of money over time. It is an essential part of the opportunity cost that will either give the decision maker the incentive or disincentive to bye a capital good.
In Capital budgeting, it is a mechanism for investors to find the current value of a capital good against its value in the future. The concept of Time value of money is closely related to interest rate which leads to the discount factor. Why Time value of money is used? The investment decision involves selection between proposed options of capital goods and their replacement decisions. This selection requires judgments concerning future events which are unpredictable. For this one has to consider time and risk.
So for that time, we want to know the present value of our money as well as the future value of the invested money that is how much interest we will earn and in case we are investing the current amount of money then are we getting the equal or more profit or benefit from the future amount of that money. It helps in taking decision whether we should invest in new project, in purchase of new machinery or on other capital goods or not.