Why is it desirable to construct capital budgeting rules so that higher-risk projects become less acceptable than lower-risk projects?
Capital budgeting is the technique used by firms to decide the type of investment to consider. The investments are always long term, and therefore specific rules in budgeting are considered. The rules considered should address the cash flow of the project, and the time value. According to Arthur and Steven (2003), the capital budgeting rules consider the payback period of the investment, profitability index, the net present value and the internal rate of return.
The payback period of an investment illustrates the period at which the investment recovers the initial capital invested. This period is used to determine the viability of the investment. The longer the period, the higher the risk involved in the venture. Investors use this parameter to decide where they will invest their cash (Arthur and Steven, 2003). Payback period goes hand in hand with the cash flow in the investment; low cash flows result in a more extended payback period.
The internal rate of return illustrates the percentage of discount returns which is the same as the initial cash flows of the investment. Investors use this criterion in choosing projects with high risks of collapsing. Projects indicating a negative internal rate of returns illustrate high risks while the positive values indicate profits (Varshney and Maheshwari, 2010). This criterion is effective when integrated with the payback period; the two can be used to compute the profit against time for investment.
According to Varshney and Maheshwari (2010), the net present value is highly used in capital budgeting rules since it gives an illustration of the time value of the many. The NPV determines the amount of cash flowing through the investment and compares it with cash flow out of the project for the project to flow. The net present value outdoes other methods in that it is capable of calculating cash flows that are not normal; these are high outflows of cash at the end of the project. These cash flows illustrate the risks and profitability associated with investments, therefore, giving a clear insight into the future of the project.
Arthur, O and Steven, M. (2003). Economics: Principles in Action. Upper Saddle River, New Jersey, p. 375
Varshney, RL and Maheshwari KL. (2010). Managerial Economics. New Delhi, p. 881
by EssayRoyal, Dec. 7, 2019, 7:27 p.m.