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Question - In considering what we have learned thus far regarding the importance of determining the cost of capital as well using capital budgeting tools, explain why it is important to understand that capital budgeting is subject to the validity of the forecasted data. Additionally, explain whether this reduces the reliability of these types of tools. Are there any other alternatives, or are these tools some of the most reliable that currently exist?
Answer - Capital budgeting technique is used to evaluate the acceptance of a project. A company will receive various proposals for projects on a timely basis. But a company can accept only limited proposals due to limited resources. Hence, capital budgeting techniques will help the company to select proposal on the basis of various factors like profitability, etc., A project will obviously have cash inflows and cash outflows. Hence, a company will choose a project where the cash inflows generated are comparatively more than expenses.
For example, if a proposal has a life period of 5 years then it is obvious that some amount of expenses and income will occur every year. Now, capital budgeting technique is based upon the estimation of those income and expenses which would occur every year and all the tools of the capital budgeting will calculate the profitability/ return based on that estimation. For example, if NPV is used to evaluate the acceptance then all the estimated figures are discounted to today's value and the proposal is accepted if the net present value is positive (Implies profitability). If those estimated figures does not hold true then it is obvious that the capital budgeting tools will not produce correct results. For example, an investment of 100,000$ is made for a project where it is estimated that 25000$ will be generated every year.
According to pay pack method, the payback period will be 4 years. But if the project actually generates only 20,000$ every year then the pay back period will be 5 years. In brief, every capital budgeting technique is based on the forecasted data. If there is a huge difference between forecasted data and actual data then there is no use to depend upon the capital budgeting tools to compare and evaluate the proposals received. However, the concepts of data analytics and modelling have improved to an extent where the companies are able to forecast the approximate income and expenses that will occur in the future period. Hence, the capital budgeting techniques are the most reliable techniques in the current era due to the evolution of data analytics and data modelling.
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