Question one
Capital budgeting is a process that may be defined by proper understanding of the terms; capital which means the initial investment needed to kick start a business activity and budgeting which is the process of aligning resources to meet a given business goal. Capital-budgeting may be defined on the bases of the goals of a project, which are supposed to define the value of a project to the firm. Proper understanding of capital budgeting decisions is helpful in definition of the strategic decision of a firm.
Various processes should be taken into consideration while defining the use of capital-budgeting process useful in defining projects that may add value to firms. The first and most significant element that should be considered in the process is the Net Present Value (NPV). This is defined by the difference between the present value of a project in terms of inflows and the outflows in terms of cost. There should be an unbiased consideration where proper calculation should take place (Brigham & Ehrhardt, 2002). In this case, the project with the highest NPV should be evaluated on other elements for it to be considered as a probable project to be initiated by the company.
On the other hand, the Internal Rate of Return (IRR) should be considered as a paramount element to determine the most outstanding project to implement for an organization. This is a tool that may be used to forecast the returns of a project at maturity making it extremely significant. At some point, an organization may have multiple Internal Rates of Return. At such moments, excellent skills in financial skills are required to make conclusions on the best and the most reliable IRR (Holland & Torregrosa, 2008).However, the best one must contain relevant resources that would be useful in defining the success of a project.
Also, apart from the consideration of the financial requirements of the projects it would be wise to consider the availability of other resources needed to undertake the project. The availability of money in the project would not mean absolute success of the business. Extensive investment on knowledge and other resources required is equally paramount (Brigham & Ehrhardt, 2002). The project that has high projected returns, low cost on investments, low risk, and availability of resources should be implemented.
Capital budgeting decisions are extremely helpful in defining the strategic direction of a firm through different ways. The first significance is the definition of the need for capital in the bid of the direction that the firm wishes to take in terms of investments. Capital is a core element in defining the direction of a company. With adequate capital, it is possible for a company to have proper plan of how it may achieve its goals. The capital is usually useful in coming up with the budget, which forms the allocation of resources to different activities that the firm wishes to undertake (Holland & Torregrosa, 2008).
Budgeting must involve cost for resources that may be equally fundamental in defending the strategic direction of a firm. The company must identify the resources that it may require to ensure it achieves its goals or objectives. For example, if the firm deals with production, proper plan of how to acquire resources and form where they would be taken from should be undertaken (Brigham & Ehrhardt, 2002). It is through capital budgeting that the resources will be evaluated and their value defined to assist the company in making the most outstanding decision.
Question two
It is usually a challenge to choose between two mutually exclusive projects. It would be more confusing if there were short-term and long-term projects. However, it becomes extremely difficult to define the best project is when they are both ranked in terms of the NPV. In most cases, the short-term project may be ranked higher in terms of NPV than the long-term project.
As the term NPV dictates, the net present value of a project is extremely useful in defining the reliability of a project. NPV is usually useful in defining the urgency of having a project produce returns. In most cases, short-term projects will have higher returns than long-term projects. This is because, the investments that are made will be required to give fast returns and must show sense for financial flow. It must have direct and fast contribution to the income of the investors. Under low cost of capital, the short-term project would be deemed better than long-term project following various elements. The first element is the projected rate of returns for the project. Rate or returns is usually dependent on the time that may be required to start gaining from a project. This means that short-term project will consume lesser time than long-term project in producing the needed results. Although, NPV does not rely, so much on rate of return, it requires being considerate of the period as it may be relevant for definition of the period that investors would be willing to wait for their returns. Short-term project will give faster returns than long-term projects, which will force the investor to wait for extremely long and it may not be the most appealing experience for investors with short-term aims on returns. It may be concluded by saying that under low cost capital, short-term projects would give faster and more returns than in the long-term projects where a lot of time may be consumed only to bring forth minimal returns (Holland & Torregrosa, 2008).
Under mutually exclusive projects, changes in the cost of capital would cause exclusive change in the IRR ranking of short-term and long-term projects. It is worth noting that cost is a paramount element in defining the output or returns of a project. The amount of money invested, which is the cost is highly influential to the amount of money that the investor is likely to get from the project as returns (Brigham & Ehrhardt, 2002).
Short-term project means that the investment made should have its returns realized immediately or after short period of time. On the other hand, long-term projects would be required to show their returns after a short period. Therefore, cost of capital would be extremely useful in the determination of the returns of the projects. For short-term projects, cost of capital changes would have direct or immediate effect on the returns. Within a small period of operations in the project some changes will have already been realized. Long-term projects are likely to experience the most effective force as a result of change in cost of capital. These projects involve exclusive process that takes an extremely long time (Brigham & Ehrhardt, 2002). This means that there will be changes that will be experienced form time to time. These changes will be highly influential to the performance of the projects. Therefore, the IRR of long-term projects will experience extensive decrease.
References
Brigham, E. F., & Ehrhardt, M. C. (2002). the basics of capital budgeting: Evaluating Cashflows. Financial management, theory and practice, 10th edition (p. 425). Australia: South-Western/Thomson Learning.
Holland, J., & Torregrosa, D. (2008).Capital budgeting. Washington, D.C.: Congress of the U.S., Congressional Budget Office.
