Question

Please answer this not taken from the web answer, define capital budgeting tools/techniques and please explain the potential problems in implementing them, thank you

Answer 1

Capital budgeting is the process of analysing proposed investments in future projects and deciding whether they will be profitable for the business. There are various capital budgeting techniques such as payback period, internal rate of return and net present value method which is the most popular method.

Under the payback period the decision is made based upon the period in which the initial investment is recovered. Under the internal rate of return method the project is accepted if its internal rate of return is higher than the opportunity cost. Under Net present value method the project is accepted if the npv is positive. The main problems in implementing these methods are as follows

It is difficult to predict the cash flows accurately

Estimating the opportunity cost of capital is a difficult task and even a slight change changes the entire decision.

Estimation of inflation rate is required which is difficult over a very large period of time

Different techniques may give different results and this creates confusion.