Coursework Completion – Coursework Example
Traps in modern capital budgeting Traps in modern capital budgeting The in the article ‘what is wrong, with modern capital budgeting’ draws his premise mainly from the assumptions of capital budgeting. He indicates the reality that, it is erroneous for modern capital budgeters to assume perfect market models, when such models hardly exist in reality. The author indicates that, it would be imprudent to assume that a project’s level of risk in an entity is not affected by the overall risk affecting the organization as assumed in capital budgeting. In the article ‘innovation killer’, the author draws from the weaknesses of discounted cash flows. Of more importance, he focuses on stop loss option, an option that is hardly recognized in capital budgeting.
The above premises are right in regard to the emphases on firm level risk, assuming that the level of risk in a project is not affected by the organizations overall risk is imprudent (Baker, & English, 2011). For instance, an entity may be at the blink of falling into financial distress. In such a case, it does not imply that the entity is not having some cash reserves. The entity can invest such little cash in a small project whose net present value over the next ten years is very high. In spite of this, the risk of financial distress and bankruptcy may interrupt realization of such cash flows
From the above presentation, it is clear that capital budgeting techniques hinder innovations by managers, by offering limited decision options when in real life application, many alternatives do exist (Baker, & English, 2011). For instance, it would be prudent for managers to invest resources at 6%, way below 12% cost of equity, if the only remaining alternative is to let the cash lie idle through out the investment period in question.
Baker, H. K., & English, P. (2011). Capital budgeting valuation: Financial analysis for todays
investment projects. Hoboken, N.J: Wiley.