Capital Budgeting Techniques and their Relation with Wealth Maximization

This article discusses the importance of capital budgeting techniques in making investment decisions and their relation with wealth maximization. It explains the significance of NPV, cost of capital, and other techniques like ARR, IRR, Payback Period, and Profitability Index. The article also highlights the need to consider risk and materiality while investing in projects. The subject is finance and the document type is an essay.

Finance
Finance
Name of the Student
Name of the University
Author Note
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.

4. Internal Rate of Return – This is also a technique for capital budgeting as in this the
company can discount the return of the rate and ability to get discounted NPV which will
help them to know the proper amount of profit from the project (Fisher 2018). This
project helps the company to understand how efficient the investment decision is and
how easily company will able to get a return from the project, it takes into consideration
of time value of money as the IRR help the company how much the company can get
more from the investment.
5. Profitability Index – This index helps the company how easily pay off the initial
investment of the project (Fleten et al., 2016). It helps the company to rank the projects as
if the company is having many projects so it should able to rank the project so that, the
company will able to know about each product easily and which will help them to choose
the most appropriate project for investment purpose.
This are the technique apart from NPV which should be taken into consideration while deciding
about the investment in different projects, apart from these company all should take various
aspects as t should check the risk which is associated with the project as it should check the
materiality of the project which is there so that it can know about the uncertainty in the company.
If the project is having a high amount of risk than the company should not take it into
consideration as if the company is investing risky high plan than it will directly affect company
financial position, maybe company will get huge return but if the company is not able to get back
the money than it is not good to do such kind of investment (Gallo 2014). So a company should
also check the risk factor before investing in the business as if the company is not checking the
risk then it will not be able to create a proper investment which will also affect upon the wealth
maximization of capital in the business.
Question No 3
Cost of capital is the amount of return which is needed by the company to get proper investment
in the capital so that it can able to get the appropriate amount of profit from the project. This
metric is used by the company so that it can able to know about capital project as it is good for
the company to invest in the project as if the company is not able to get proper amount of return
from the business then it will able to carry its business operation easily and effectively (Gitman,
Juchau & Flanagan 2015). It includes both the cost of equity as well as the cost of debt so that it
can able to know about the value of the project more efficiently.
Cost of Equity shows about the return which the company can pay to its shareholder, as this
reward is given to company shareholder as they are the one who undertakes the risk of investing
their money in company financial statement (Goh et al., 2016). As each company requires a
considerable amount of fund so that it can able the business and to get the same the company has
to go for many options so as a different user is investing the money in company business so in
return the company is giving them reward which is termed as cost of equity. As shareholder
termed as an owner of the company so due to these they are not able to get any kind of interest so
to overcome that company can pay the same amount as a reward to a company (Harjoto & Jo
2015). Cost of equity calculated with the help of many models, which are:

1. CAPM Model – This model stands for Capital Asset Pricing Model which help the
company to know about the cost of equity, as it undertakes the market risk which
associated in the market that is also represented by Beta, also it takes into consideration
the expected return which the company is able to get from the market (Kengatharan
2016). The formula of the CAPM Model is (Expected return – Risk-Free
Return)/Beta. So after taking all the aspects it able to show about the cost of capital of
the company.
2. Gordon Model – It is the method from which the company can ascertain the cost of
equity of a company as it keeps the base of the net present value of the future dividend of
the company (Kumar & Goyal 2015). The formula which used under this is Value of
next year Dividend/ (cost of equity capital – constant growth of dividend expected).
3. Bond Yield Plus Risk Premium – It is also a method which helps the company to
calculate the cost of capital as this take into consideration about the company long term
debt as in this risk premium is added with firm long term debt of the company (Leung et
al., 2014).
So this is the way from which the company will able to meet the requirement of cost of capital
and able to calculate the same so from the above company will able to know about the
shareholder expectation which termed as cost of capital.
Cost of Debenture is the rate from which can pay its long term debt, as it takes into consideration
about the company payment of a debt after tax so that it can able to know the original amount of
debt which is to be paid by the company (Levy 2015). As the company has many processes from
which they able to get more amount of finance so should take into consideration about the long
term debt which the company has decided to carry its business operation quickly and effectively.
Company has to manage the finance cost also so it should consider the same while making an
investment in any proposal. It calculated as Interest Expenses (1-Tax rate).
The above show about the company calculation of the cost of debt so that the company can know
how much it will able to pay to the financial institution so that it can able to manage the finance
cost of the company.
So after the calculation of both the above mention points it will able to get a cost of capital so
after getting the cost it should analysis the same with the capital budgeting so that it can know
about the company return as the cost of capital as this show the amount of money which the
company have to spend to get the amount of finance in the company but as if the company is
able to get less than the cost of capital than it should not be able to invest in the project (Li &
Mohanram 2014). As the company should match both rates so that it can able know whether the
project can give the company the required amount of return that will help the company to carry
its business activities more efficiently and effectively. So if the company is having more return
than only its should bale to accept the proposal and able to proceed with the investment.
For example if the company is having a cost of capital at 15% but in capital budgeting it able to
get 12% so as the company is able to get less amount of return so it should not accept the
proposal as the company have to pay more than what it will able to get from the investment so
that it should not be able to accept the proposal. As if the company can get more than the cost of

capital than only it will able to accept the offer. This help the company to manage its business
operation properly and effectively in the company business.
Question No 4
Cost of a capital show about the amount of money which the company has to spend so that it will
able to get the amount of finance as if the company have to spend in the business so it should
have a proper record of the business (Minsky 2016). As the company can check the cost of
capital so that it will able to get an appropriate amount of return from the company.
Constant cost of capital is the cost which the company has to spend upon the finance of the
investment so it should take into consideration while choosing the proposal (Petković et al.,
2016). So the company has a fixed cost of capital, which helps the company to make a proper
amount of investment of the company.
Change in cost of capital not usually found as the company is only able to maintain a proper
amount of money as if the company can fluctuate the value of funds only in some necessary
conditions (Rossi 2014). As if the company can invest in the project which can have in the same
type of investment which the company can carry its business activities. As if the company can
deal in real estate so it will able to invest in the fixed cost of capital.
If the company is able to invest in the project in which they are is able to have high risk so if the
company is able to invest in a project than the company is able to have the high cost of capital so
that it can able to manage the high amount of risk which is associated with the same. So that the
company can meet the requirement of the business (Rossi 2015). Company is making a risky
investment, so in order to bear the risk, the company has to expect a high return from the
investment. The company can charge high mount so that it can able to minimize the risk which is
associated with the project.
If the company is able to invest in the project in which their less amount of risk so that the
company is investing in less amount of risk for that reason is able to lower the cost of capital so
that the company is able to get proper amount of return from the same (Sayadi et al., 2014). As
the company is investing in the project in which there is less amount of risk so as the company is
highly secured so in return it able to get less amount of cost of capital so that it can able to invest
in the project more efficiently and effectively.
So usually, the company is able to carry its investment proposal in normal or constant cost of
capital when the company is able to invest as per the industry norms and regulation (Shoup
2017) as the company is investing in the project which has normal risk so it should take into
consideration the constant cost of capital. If the company is investing in the project which is
having a high amount of risk so to do the same, it has to charge more than the cost of capital as
this will help the company to gain the reward for getting more amount of risk in the project
(Soros 2015) if the company can invest in the project that is having a less amount of risk so it
will able to have a security of money so as a result, it will able to have a less amount of cost of
capital in the business.

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