Independent vs. Mutually Exclusive Projects in Capital Budgeting
Independent projects are projects which are unrelated to each other, and that allows for each project to be assessed based on its profitability. For example, if projects A and B are independent, and both projects are profitable, then the firm could accept both projects. Mutually exclusive means that only one project in a set of feasible projects can be approved and that the projects face with each other. If projects A and B were mutually exclusive, the firm could accept either Project A or Project B, but not both. A capital budgeting decision of choosing between two different food processing machines with various costs and output would be an example of deciding between two mutually exclusive projects. The NPV and IRR methods make the same accept/reject decisions for independent projects, but if plans are mutually exclusive, then ranking conflicts can arise. If disputes occur while deciding on mutually exclusive projects, the Net Present Value (NPV) method should be given preference. The Net Present Value (NPV) method is more realistic reinvestment rate assumption. The Internal Rate of Return (IRR) and Net Present Value, both approaches are preferred to the payback period, but the latter is considered superior to the former.
Unlimited Funds vs. Capital Rationing in Capital Budgeting
When the firm has unlimited access to capital, then it can undertake all independent projects with predicted returns that exceed the cost of money, but in reality, this hardly happens. The accept-reject approach involves the evaluation of capital expenditure proposals to determine whether they meet the firm’s minimum acceptance criteria based on the required rate of return. But in most of the cases, many firms have constraints on the amount of capital they can raise (using both Equity and Debt) and must use resources rationing. If a company’s profitable project opportunities exceed the number of funds available, the firm must prioritize or ranks the project. The goal should be of achieving the maximum increase in value for shareholders with the given available capital. The ranking approach in capital rationing involves the ranking of capital expenditures based on some proposed measure, such as the rate of return. The funds must be allocated to achieve the maximum shareholder value subject to the funding constraints.
Net Present Value (NPV) in Capital Budgeting
NPV is the difference between Discounted Cash Inflow and Cash outflow. NPV is used in capital budgeting to investigate the profitability of an investment or project. NPV can be positive or negative depending upon the discounted Cash Inflow. If discounted cash inflow is more than cash flow, then it is positive; otherwise, it is negative. NPV equates the value of a rupee today to the amount of that same rupee in the future, taking inflation, risk, and returns into account. If the NPV of a project comes out positive, then the project should be accepted. If NPV comes negative, the plan should be rejected because cash flows will also be negative. NPV analysis is sensitive to the security of future cash inflows that an investment or project will yield. Example- A soap manufacturing plant wants to take over another existing plant then it should at first analyze the future cash flow to be generated from the sales of soaps after meeting all the fixed and variable expenses and then discount those cash flows into one lump-sum present value amount, say $500,000. If the owner of the plant were willing to sell his plant for less than $500,000, the company buying the plant would likely accept the offer as it presents a positive NPV investment. If the price offered by the selling company is more than the expected cash flow generation, then the NPV is said to be negative.