Capital budgeting is the process assumed by a firm to make long-term decisions, which have a direct effect on the investment of the company or business for that matter. It determines whether an organization’s long-term objectives are worth pursuing and budgets on the substantial capital investment of a business and the expenditures.
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Capital budgeting projects generate the cash flows for years. Any capital budgeting project can be accepted or rejected depending on its effect on the net value and internal rate of return method (Good pasture, 2004). Some characteristics of capital budgeting projects may cause the net present value and the rate of return method to the ranking of the projects to be extremely differently.
Characteristics of mutually exclusive capital budgeting projects
In mutually exclusive budgeting projects, only one of the projects is chosen. The selection is in accordance to the effect on Net Present value and internal rate of return. However, these characteristics do not consider the future cash flows of the business in the future. As a result, the flow of cash, if discounted comparing with the cost of capital, is not effective. This event is extraordinarily dangerous because the project may not last for a long time (Brigham & Houston, 2008).
These types of budgeting fail to consider the period that can lead to the recovery of the capital outlay for the budgeted project. These types use the shortest payback period not considering the risks that may occur such as losses and administrative complications at the end of cash flow of the business if negative. These mutually exclusive projects may fail to maximize the wealth of the shareholders hence may not so effective.
Compared to the independent projects, which focus more on maintaining the cash flows in cases of accepting or rejecting of a decision meant for other projects, many differences arise. However, for the decision-making manager, it is wise to figure out the impacts that are mutually exclusive to the relevant projects and can result to the desired outcome.
Mostly, these are only acceptable when dealing with a small business and not in cases where lots of money is involved (Keown, 2004). A manager should be keen to find out what suits the firm best and after what period. Cash flows of a firm operating with lots of money is necessary for constant growth of the business.
When making a decision for a firm, it is necessary to calculate the internal rate of return in order to find out which is the best project to undertake and maximize profits. However, depending on the properties of a significant capital budgeting, it is wise for a project chosen to consider the cash flows of a firm in the future.
However, the budget that maximizes the wealth of the shareholders is the best to choose when making a decision (Baker & Powell, 2005). Therefore, before making any decision for a firm’s budget, a lot of concern must be part of the considerations set to ensure that all strategies work as planned. In many cases, risks are always there, and they profoundly affect the budget of any firm. Therefore, it is better to prevent risks and maintain the flow of cash.
Baker, H. & Powell, G. (2005). Understanding Financial Management: A practical Guide. London: Blackwell Publishing Ltd.
Brigham, E. & Houston, J. (2008). Fundamentals of Financial Managemet. NewYork: Cengage Leaning.
GoodPasture, J. (2004). Quantitative Methods in Project Management. Washiongton D.C: J. Ross Publishing Inc.
Keown, A. (2004). Foundations of Finance: The Logic & Practice of Financial Management. Hong Kong: Tsingua University Press.