Financial managers need to take decisions about different investment projects and also make sure a minimum rate of retum from those projects. Illustrate the reasons of calculating cost of capital before making any investment decisions?
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Answers
Capital budgeting involves choosing projects that add value to a company. The capital budgeting process can involve almost anything including acquiring land or purchasing fixed assets like a new truck or machinery. Corporations are typically required, or at least recommended, to undertake those projects which will increase profitability and thus enhance shareholders' wealth.
However, what rate of return is deemed acceptable or unacceptable is influenced by other factors that are specific to the company as well as the project. For example, a social or charitable project is often not approved based on the rate of return, but more on the desire of a business to foster goodwill and contribute back to its community.
Understanding Capital Budgeting
Capital budgeting is important because it creates accountability and measurability. Any business that seeks to invest its resources in a project, without understanding the risks and returns involved, would be held as irresponsible by its owners or shareholders. Furthermore, if a business has no way of measuring the effectiveness of its investment decisions, chances are that the business will have little chance of surviving in the competitive marketplaceBusinesses (aside from non-profits) exist to earn profits. The capital budgeting process is a measurable way for businesses to determine the long-term economic and financial profitability of any investment project.
How Capital Budgeting Works
When a firm is presented with a capital budgeting decision, one of its first tasks is to determine whether or not the project will prove to be profitable. The payback period (PB), internal rate of return (IRR) and net present value (NPV) methods are the most common approaches to project selection. Although an ideal capital budgeting solution is such that all three metrics will indicate the same decision, these approaches will often produce contradictory results. Depending on management's preferences and selection criteria, more emphasis will be put on one approach over another. Nonetheless, there are common advantages and disadvantage associated with these widely used valuation methods.