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...
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