Capital budgeting refers to the total process of generating, evaluating, selecting and following up on capital expenditure alternatives. The firm allocates or budgets financial resources to new investment proposals. Basically, the firm may be confronted with three types of capital budgeting decisions i) the accept/reject decision,
ii) the mutually exclusively choice decision and
iii) the capital rationing decision.
i) Asset – reject decision:
This is a fundamental decision in capital budgeting if the project is accepted; the firm would invest in it. In general, all those proposals which yield a rate of return greater than a certain required rate of return or cost of capital are accepted and the rest are rejected. By applying this criterion, all independent projects are accepted. Independent projects are projects that do not compete with one another in such a way that the acceptance of one precludes the possibility of acceptance of another. Under the accept reject decision, all independent projects that satisfy the minimum investment criterion should be implemented.
ii) Mutually exclusive project decisions:
Mutually exclusive projects are those which complete with other projects in such a way that the acceptance of one will exclude the acceptance of the other projects. The alternatives are mutually exclusive and only one may be chosen. Let us imagine that a company is intending to buy new folding machine. There are three competing brands, each with a different initial investment and operating costs. The three machines represent mutually exclusive alternatives, as only one of these can be selected. It may be noted here that the mutually exclusive project decisions are not independent of the accept reject decisions. The project(s) should also be acceptable under the latter decision. In brief, in the example mentioned above, if all the machines are rejected under the accept reject decision, the firm should not buy a new machine. Mutually exclusive investment decisions acquire significance when more than one proposal is acceptable under the accept reject decision. Then, some technique has to be used to determine the best one. The acceptance of this best alternative automatically eliminates the other alternatives.
The Essay on Investment Decision Methods
... the two projects are independent or mutually exclusive. For the independent projects accept all projects which have a NPV greater than zero. While for mutually exclusive projects; the project with ... suitable rate chosen by the analyst. When making the accept reject decision the project should be accepted when the MIRR is greater than the NPV ...
iii) Capital rationing decision:
In a situation, where the firm has unlimited funds, all independent investment proposals yielding return greater than some predetermined level are accepted. However, this situation does not prevail in most of the business firms in actual practice. They have a fixed capital budget. A large number of investment proposals compete for these limited funds. The firm must, therefore, ration them. The firm allocates funds to projects in a manner that it maximizes long term returns. Thus capital rationing refers to a situation in which a firm has acceptable investments than it can finance. It is concerned with the selection of a group of investment proposal out of many investment proposals acceptable under the accept reject decision. Capital rationing employs reaching of the acceptable investment projects. The projects can be racked on the basis of a predetermined criterion such as the rate of return. The projects are ranked in the descending order of the rate of return
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