1) We know that capital budgeting is a forward looking process based on sales/re

Question

1) We know that capital budgeting is a forward looking process based on sales/revenue and expense projections which convert to operating cash flows which are then discounted to the present and compared to the project cost. Briefly EXPLAIN this process and make sure you cover issues with respect to estimation errors and how this may impact net present value (NPV) and IRR results.

Now, what does positive net present value mean? How is it that the firm will succeed in earning a return above the one you would expect given the risk of the project under consideration? Discuss the possible sources of positive net present value and why is it critical to understand its source?

Explanation / Answer

Capital budgeting is the planning process used to determine whether an organization's long term investments such as new machinery, replacement machinery, new plants, new products, and research development projects are worth the funding of cash through the firm's capitalization structure (debt, equity or retained earnings).

It is the process of allocating resources for major capital, or investment, expenditures.One of the primary goals of capital budgeting investments is to increase the value of the firm to the shareholders.

In this process only incremental cash flows are considered for evaluation. Incremental means cash flows which wil have impact on project under discusssion. Sunk costs like marketing research expenses are ignored, All the sales and expenses projections are done to arrive at final cash flows which are then disocunted using weighted average of cost of capital or cost of equity as the case may be.

Main probelm areas in this process are estimating cash flows correctly. Sometimes analyst overestimate the cash flows on optimistic assumptions which leads to inflated NPV causing wrong decisions. Suppose analyst estimate that company will continue to grow at CAGR of 20% for 10 years but in fact it grows at 10-15%. Then this overestimated cash flows will cause NPV to be higher than realizable NPV.

Same may be case of underestimation of cash flows in which case NPV would be smaller than the actual and may lead to rejection of a good or viable proejct.

IRR is also affected by wrong cashflows.Overestimating cash flows will pull IRR lower which will in turn result false represntation about vaibility of a proejct.

Positive NPV confirms that the investment’s cash flow will sufficiently compensate its costs, the cost of financing and the underlying cash flow risks.The purpose of net present value is to help analysts and managers decide whether or not new projects are financially viable. Essentially, net present value measures the total amount of gain or loss a project will produce compared to the amount that could be earned simply by saving the money in a bank or investing it in some other opportunity that generates a return equal to the discount rate. If a long-term project has a positive net present value, then it is expected to produce more income than what could be gained by earning the discount rate, which means the company should go ahead with the project.

There is always trade off between risk and return. The more retruns generated per degree of risk taken is measured by various parameters. The risk of the project is nothing but uncertainty about adverse impact. But due to increased risk proejct also earns higher returns.

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