Capital Budgeting Techniques and their Relation with Wealth Maximization

Finance
Finance
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Table of Contents
Question 1
Question No 2
Question No 3
Question No 4
Reference
Question 1
Capital Budgeting is the process from which the company plans its investment decision, so a
company has to carry many options available to choose the most appropriate option it takes help
from capital budgeting (Andor, Mohanty & Toth 2015). Capital Budgeting help the company to
increase overall shareholder value in the company as if the company is able to invest correctly it
will able to have wealth maximization that will help the company to expand its business
operation quickly in business as well as it will help the company to give more amount of return
to its shareholders (Antoniou, Doukas & Subrahmanyam 2015). The company can carry capital
budgeting with the help of different techniques, as each method can analyze the project and able
to give the company a proper amount of result. The company has to invest in a different kind of
project so they must check all the aspects of the proposal so that it will be able to meet their
investment more efficiently and effectively. The most used technique is NPV as this help the
company to decide whether it can able to invest in the company or not (Thippayana 2014).
NPV stands for Net Present Value, that is a kind of capital budgeting technique and helps the
company to know about the project as, from it, the company can select the most appropriate plan
regarding profit. This process helps the company to know about the project more practically so
that the company is able NPV calculated by Deducting Present Value Inflow with Present Value
of Outflow (Arcand, Berkes & Panizza 2015). It helps the company to know about the profit it
will able to get from investing in the project. NPV Relation with Wealth Maximization
NPV help the company to gain more amount of benefit from the project, which indirectly helps
the company to get more amount of wealth maximization in the investment proposal. The ways
are shown below:

1. Positive NPV – Company should able to invest correctly and to get proper return it
should able to invest in a project which is having a positive NPV as if the company
proposal has a positive return that shows the company will able to gain a proper amount
of profit from the business (Batra & Verma 2017). As the performance which company
will get, that will help them to carry the money and able to make it as a wealth
maximization in the company financial statement. If the company is not able to get more
amount of profit than it will very hard for the company to manage its business operation,
so it is required by the company to invest the money in which company can handle all the
finance activity quickly and effectively.
2. Less Risky Project – Company should not only check the positive NPV but also it
should check the amount of risk which is been associated with the project, as if the
project will have a high amount of risk that can also lead the loss to the company as if the
project is not able to succeed than company will have to decline the money so it should
invest in less risky project as it will help the company to do wealth maximization easily
and effectively (Brooks 2019). The company is able to spend high amount of money in
the project so they must get more than the amount which is ready to be invested in the
project so that it is able to carry its business cost easily so if the proposal is giving a
negative return so the company should not spend the same in the project. As if the
company has high-risk amount then it will not be a good idea for the company to pay the
same as it required huge amount so if the company is taking such risk and some uncertain
event occurs then it will directly affect the company financial position as well as it will
also lead the company to insolvency.
3. Different Product – As the company is a concern if the company is investing in a
project, but if it is affecting the different company product, then it will not be able to
carry with the proposal. So for example company is dealing in cold drink and it got a
project of a health drink so if the company is shifting from cold drink to health drink, that
will result in loss of customer as if the company is selecting option it will lose the
customer who is used to consume cold drink of the company. So the company has to
consider this the same before making any investment in such kind of proposal.
Value of firm show about the total amount of the firm as it takes into consideration the total
equity and total debt of the company. It is the total value of company as some other company
want to take over another firm, then it has to take consideration the value of the firm (Chava
2014). Value of the firm is not related to NPV as it not consider the profit which the company is
earning from investing in different project, but if indirectly it is related to NPV as if the project
have a positive NPV than it will help them to do wealth maximization which help the company
to have high amount of capital that will increase the overall of equity, that will increase the value
of firm. If the company is able to have an increase in total equity that will directly increase the
value of firm, which is a good sign as it will help the company to have an increase in the value of
a firm so this will help the company to gain more value in the firm (Cheng, Ioannou & Serafeim
2014).
A company should not be able to accept any project which is having a negative NPV, as if the
company project has a negative NPV than it will directly decrease the value of the firm. If the
company project is having a negative NPV than it will reduce the value of the firm and also
company is not able to meet proper amount of requirement of the business as negative show that
the company will not be able to have any amount of profit from the investment, that will also

affect the company as if the company does not have any profit from the investment than it is not
value as only the company will waste their investment as if company is not having any return
than what is the need of investing in such projects so if the company proposal has any negative
return it should not take that into consideration while making the decision in regards of capital
investment (Core, Hail & Verdi 2015).
Question No 2
Capital Budgeting decision should help the company to know about the different aspects of the
project so the company should able to analysis the project from many techniques so that it will
able to see every aspect of the project. Solely if the company is only depending upon the NPV
than it will not be able to know all the elements (Dhaliwal et al., 2016). NPV only able to show
the profit aspect of the project, but it should also check the same with other techniques so that the
company will be able to know about the different elements of the project. The different technique
which the company should use are:
1. Accounting Rate of Return - It is a technique of capital budgeting as this method use
financial ratio to analysis the project. As it does not take into consideration the concept of
time value of money, it able to calculate the return from the net income of the project as
if the company is having an ARR OF 8% this signifies that the company is earning 8
cents from each dollar it has spent in the business (Dhaliwal et al., 2014). So it able to
know how much the company can get return upon the investment done by the same. This
help the company to meet the reasonable expectation of the company as it shows the
company required the amount of investment in the project.
2. Average Accounting Return – It is also a technique to analyze the project as show the
return which the company will get after deducting tax and depreciation from the project.
It calculated as average project earnings divided by the average book value of investment
(Easton & Monahan 2016). It helps the company to know the actual return which the
company will get after completing all the expenses, the net amount which the company
will get from the project. As the company can know the amount of return so this helps
them to plan the investment more quickly and effectively in the company.
3. Payback Period – This method is used to know about how the company will able the
money back in years, as this technique helps the company to know about the break-even
point of the project (El-Geneidy et al., 2016). In the time value of money is not taken into
consideration. As if company have invested a sum of $20000 in a project and in 1st year
it got 8000 as return and in second year 12000 so payback period will be 2 years as the
company will able to get back the initial investment back in 2 years so this signifies that
the company is getting its stake in 2 years (Žižlavský 2014). This help the company to
know how early the company can get the initial investment, which is done in the project.
This process show that how soon the company is able to get back their investment so if
the company is able to know the time duration, which will help the company to get a plan
of how to move forward in the business as well as it helps them to manage the cost of
finance which is associated with the project. As the company has to borrow the initial
investment so if it able to pay back early than the total finance cost will decrease as will
decrease and also it will give an increase to company business activities.