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Capital Budgeting Decisions

Internal Rate of Return Assignment / Homework Help
Types of Capital Budgeting Decisions

A business organization has to quite often face the problem of capital investment decisions. Capital investment refers to the investment in projects whose results would be available only after a year. The investment in these projects are quite heavy and to be made immediately, but the returns will be available only after a period of time. The following are some of the cases where heavy capital investment may be necessary:

  • Replacement: Replacements of fixed assets may become necessary either on account of their being worn out or becoming outdated on account of new technology.
  • Expansion: A firm may have to expand its production capacity on account of high demand for its products and inadequate production capacity. This will need additional capital investment.
  • Diversification: A business may like to reduce its risk by operating in several markets rather than in a single market. In such cases, capital investment may become necessary for purchase of new machinery and facilities to handle the new products.
  • Research and Development: In case of those industries where technology is rapidly changing, large sums of money may have to be expended for research and development.
  • Miscellaneous: A firm may have to invest money in projects which do not directly help in achieving profit oriented goals. For example, installation of pollution control equipment may be necessary on account of legal requirements. Thus, funds will be required for such purpose also.

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Capital budgeting decisions are among the most crucial and critical business decisions. Special care should be taken in making these decisions on account of the following reasons:

  • Involvement of heavy funds
  • Long-term implications
  • Irreversible decisions
  • Most difficult to make

A firm may face several investment proposals for consideration. It may adopt one of them, some of them or all of them depending upon whether they are independent or dependent or mutually exclusive.

The firm may face basically with three types of major decisions:
  • Accept/Reject Decisions
  • Mutually exclusive Project Decisions
  • Capital Rationing Decision

  • Accept/Reject Decisions

    A firm may accept a project if the expected returns are more than the cut-off rate fixed by the management. The cut-off rate is usually the cost of capital of the firm. A firm may reject a project if the expected returns are lower than the cut-off rate. The decision making techniques are many which includes pay-back period method, NPV method, IRR method etc. These accept/reject decision is important because if the firm accepts the project, it will invest heavy funds in it.

    Independent Proposals (Projects): Independent proposals are those proposals which do not compete with each other in a way that acceptance of one eliminate the possibility of acceptance of another. In case of such proposal, the firm may straight away “accept or reject” a proposal on the basis of a minimum return of investment required. All those proposals which give higher return than a certain desired rate of return are accepted and the rest are rejected.

    Dependent Proposals (Projects): These are those proposals whose acceptance depends on the acceptance of one or more other proposals. If the other dependent project is accepted based on the above stated technique, this project would be accepted.
  • Mutually exclusive Project Decisions

    These are proposals which compete with each other in way that acceptance of one eliminates the possibility of acceptance of another. For example, if a company is considering investment in one of the two temperature control systems, acceptance of one system will rule out the acceptance of another. Thus, two or more mutually exclusive projects cannot both or all be accepted. The capital appraisal technique will be used for selected the best alternative and once this is done, other alternatives will be straight-away eliminated.
  • Capital Rationing Decision

    In the real world, there is a constraint to the supply of capital particularly from external sources. In view of the availability of limited amount of capital, a company sets an absolute limit on the extent of capital budget for a year. Such a state or situation is called as capital rationing. Under capital rationing the company has a fixed capital budget that it may not exceed. So, when the company has more acceptable projects than it can afford to invest, it will rank the available projects in descending order of profitability index or the rate of expected returns and then will decide on the best ones.