Kinds Of Capital Budgeting Decisions:
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 tress types of capital decisions: (i) the accept- reject decision; (ii) the mutually exclusive choice decision; and (iii) the capital rationing decision.
(i) The Accept- Reject Decision:
This is a fundamental decision in capital budgeting. If the project is accepted, the firm invests in it; if the proposal is rejected, the firm does not 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 is accepted and the rest, are rejected. Under the accept- reject decision, all the independent projects that satisfy the minimum investment criterion should be implemented.
(ii) Mutually Excusive Project Decisions:
Mutually exclusive projects are projects, which compete 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. Suppose, a company is intending to buy a new folding machine. There are three competing brands, each with different initial investment and operating costs. The three machines represent mutually exclusive alternatives, as only one of the three machines can be selected. Mutually excusive investment decisions acquire significance when more than one proposal is acceptable under the accept- reject decision. Then some techniques have to be used to determine the “best” one. The acceptance of this “best” alternative automatically eliminates the other alternatives.
(iii) Capital Rationing Decision:
In a situation where the firm has unlimited funds, capital budgeting becomes a very simple process in that all independent investment proposals yielding return greater than some predetermined level are accepted. However, this is not the situation prevailing in most of the business firms in the real world. They have a fix 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- run returns. Thus, capital rationing refers to the situation in which the firm has more acceptable investments, requiring a greater amount of finance than is available with the firm. Ranking of the investment projects is employed in capital rationing. Projects can be ranked on the basis of some pre-determined criterion such as the rate of return. The project with the highest return is ranked first and the project with the lowest acceptable return last. The projects are ranked in the descending order of the rate of return. It may be noted that only acceptable projects should be ranked.
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