Capital Budgeting

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Week 4 Discussion Question 1b Introduction Capital budgeting is one of the most crucial decisions the financial manager of any firm is faced with...Over the years the need for relevant information has inspired several studies that can assist firms to make better decisions. These models are assigned so that they make the best allocation of resources. Early research shows that methods such as payback model was more widely used which is basically just determining the length of time required for the firm to recover the outlay of cash and the return the project will generate. Other models just basically employed the concept of the time value of money. We have seen that more current models are attempting to include their analysis factors that…show more content…
Practical problems associated with the Cash Flow estimations Several decision makers have criticized the cash flow estimations as they simply do not agree with the decisions they have arrived at from the use of the models. Since there are uncertainties involved in terms of estimates of cash flows some managers become reluctant to use this method as a part of their decision making process as the calculations are far in the future. Therefore, they will take into consideration the near term cash flows. Other managers may have predetermined notions about which project to adopt and may therefore play with the numbers to achieve a desired result (Brealey, 1984). This can be a problem as the results they receive are not from faulty models but from the manager’s inappropriate inputs into the models. Another area of concern is the selection or choice of discount rate (Cooper et.al, 2001). For example if they use an inappropriately high discount rate then this could yield high hurdle rates or conversely if the rate is too low it yields lower rates. What Cooper recommends is the use of a discount rate that reflects the firms true cost of capital which is sound theory of finance advice. Thus, the best to worst case scenarios should be employed to analyze the best possible decision. When the discounted rate includes
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