Q. In considering what we have learned thus far regarding the importance of determining the cost of capital as well using capital budgeting tools, explain why it is important to understand that capital budgeting is subject to the validity of the forecasted data. Additionally, explain whether this reduces the reliability of these types of tools. Are there any other alternatives, or are these tools some of the most reliable that currently exist?
Response
It is indeed true that all technical and scientific theories, financial tools, or theories are anchored on particular assumptions. Such assumptions are imperative to the core of the core foundations or the laboratory conditions on which the theories are founded. When the laboratory conditions are effectively comprehended, technical or scientific theories offer desired results- and, therefore considered valid. A small change in any laboratory condition results in different results and also leads to the theory criticism. Similarly, if the accounting and financial theories meet reality, the results shall be considered desirable if they stand by the stipulated theories. It is also notable that reality is not the same as assumptions. At this point is where forecasted data fails on validity. The validity of forecasted data means that there are difficulties in benefits’ estimations derived out of given future investments made up of uncertainties which need to be corrected. Possibility of any substantial losses incurred in any decisions requires to be reversed. The capital budgeting tools bring a tolerance limit and minimize any uncertainties. The tools are responsive to adaptation and reality. Currently, these available capital budgeting tools are the best- for instance, accounting rate of return, discounted cash flows, internal rate of return, net present value, and real options. The success of the current tools is based on the frequent use of such tools in the past and which can be adopted by future finance managers.
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Q. In response to your peers, discuss other options that may be available as opposed to the capital budgeting techniques discussed. Also, explain your reasoning should you have a differing viewpoint from the peers regarding the efficacy of capital budgeting techniques.
Response
Yes, there are different options from the ones discussed such as growth options (Baker et al., 2010). Such options are more complex and designed into models that could as well be derivatives. The models could be used for sensitivity analysis and have algorithmic functions with different random variables. Otherwise, the capital budgeting techniques cannot be disregarded in totality.
Reference
Baker, H. K., Dutta, S., & Saadi, S. (2010). Management views on real options in capital budgeting. Journal of Applied Finance, Forthcoming .
