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…...

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