CAPITAL BUDGET PROBLEMS

Capital budgeting is a process in which the managers decide whether to invest in particular asset or not. Managers make decision whether to proceed further with the investment on a particular asset based on this analysis. This process involves analyzing the cash inflow and cash out flow outflow that might take place because of the purchase of the asset. The fund available with the company may be not surplus and hence they have to make decision based on the fund availability.

Problems faced while using capital budget methods are,

• The capital budget analysis at times gives a rate of return that is not feasible in real world. Manager must be in a position to identify those special conditions.
• In some case the capital budgeting might give two or more rates of return. This in turn will confuse the manager while making decision.
• It is difficult to balance the risk associated with the portfolio with the discount rate, how ever it must be as much closer as possible because the complete projection about the investment in the portfolio depends on the accuracy of the discount rate. If the discount rate becomes unrealistic then the entire calculation using capital budget method becomes unrealistic.
• It often becomes difficult to calculate the cash inflow and cash outflow when the asset is being used for more than one purpose.
• It often results in weird result if a bigger project with longer duration is compared with smaller project with shorter duration. This is considered as one to the biggest drawbacks of this method. It is therefore necessary to break the big project into relatively smaller project and then do the comparisons work.
• The capital budgeting method ignores the time value of the money. Time value of money cannot be ignored easily in modern day’s decision making. It is important as most of the business which are started now will yield profit only in the future.
• The capital budgeting method ignores the cash flow after the pay back period. Even though it does not have huge impact in the decision making it cannot be left ignored.
• It requires arbitrary acceptance criteria.