Types 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 three types of capital budgeting decisions:

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1.        Accept-Reject Decision

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2.       Mutually Exclusive Project Decision

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3.       Capital Rationing Decision

This is a fundamental decision in capital budgeting. If the project is accepted, the firm would invest 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 are accepted and the rest are rejected. By applying this criterion, all independent projects are accepted. Independent projects are the 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.

Mutually Exclusive Projects are those 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 a different initial investment and operating costs. The three machines represent mutually exclusive alternatives, as only one of these can be selected. Moreover, the mutually exclusive project decisions are not independent of the accept-reject decisions. The project should also be acceptable under the latter decision.

Thus, mutually exclusive projects acquire significance when more than one proposal is acceptable under the accept-reject decision.

In a situation where the firm has unlimited funds, all independent investment proposals yielding returns greater than some pre-determined level are accepted. However, this situation does not prevail in most of the business forms 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 maximises long-run returns. Thus, capital rationing refers to a situation in which a firm has more acceptable investments than it can finance. It is concerned with the selection of a group of Investment proposals out of many investment proposals acceptable under the accept-reject decision. Capital rationing employs ranking of acceptable Investment projects. These projects can be ranked on the basis of a pre-determined criterion such as the rate of return. The projects are ranked in descending order of the rate of return.