Question

How does capital budgeting decisions affect long-term borrowing rates?

Answer 1

Capital budgeting involves deciding which long term projects to invest in so that it adds value to the company. It includes buying land, machinery, or a new truck etc. Corporations main aim is to increase shareholders wealth. And as such, they need to invest money in long term projects to increase shareholder value. As capital gets blocked for a long duration of time, it is of utmost importance to take care while allocating money. Opportunity cost is huge. Risks involved are also high. Making poor capital allocation decisions can have a huge negative impact on the business and shareholders wealth.

A longer time horizon will generally require a higher return, due to an increased risk in price volatility and increased uncertainty relating to possible outcomes. In terms of long term debt investments, such as long term corporate or government bonds, a longer time horizon gives rise to uncertainties in the potential operations of the debtor entity as well as unforeseen movements in the market as a whole. In other words, default risk increases as the time horizon lengthens.

If let's say that you made a wrong decision which lead to business losing its value. Then, automatically when you reach the banks to borrow more money or the debt market, they will charge a high rate of interest. As now the risk is even higher as you had a failure. This is the reason many companies do fail. If you make good decisions and earn a good return, on the other hand, and have established yourself as a great company, then for you the long term borowwing rates would be lower. The lenders would look into the profiles of the management and the company and if your record is great, chances are high that your borrowing rate will be lower comparatively.