Key Terms and Concepts in Capital Budgeting - Financial Management

Concepts of Capital Budgeting

Before proceeding with the discussion of the capital budgeting process, it is necessary to introduce a number of terms and concepts encountered in subsequent chapters.

Cost of Capital

A firm’s cost of capital is defined as the cost of the funds supplied to it. It is also termed the required rate of return because it specifies the minimum necessary rate of return required by the firm’s investors. In this context, the cost of capital provides the firm with a basis for choosing among various capital investment projects. In this and the following two chapters, it is assumed that the cost of capital is a known value.

How Projects Are Classified

A firm usually encounters several different types of projects when making capital expenditure decisions, including independent projects, mutually exclusive projects, and contingent projects. As is demonstrated in previous Chapter , project classification can influence the investment decision process.

Independent Projects

An independent project is one whose acceptance or rejection does not directly eliminate other projects from consideration. For example, a firm may want to install a new telephone communications system in its headquarters and replace a drill press during approximately the same time. In the absence of a constraint on the availability of funds, both projects could be adopted if they meet minimum investment criteria.

Mutually Exclusive Projects

A mutually exclusive project is one whose acceptance precludes the acceptance of one or more alternative proposals. Because two mutually exclusive projects have the capacity to perform the same function for a firm, only one should be chosen. For example, BMW was faced with deciding whether it should locate its U.S. manufacturing complex in Spartanburg, South Carolina, or at one of several competing North Carolina sites. It ultimately chose the Spartanburg site; this precluded other alternatives.

Contingent Projects

A contingent project is one whose acceptance is dependent on the adoption of one or more other projects. For example, a decision by Nucor to build a new steel plant in North Carolina is contingent upon Nucor investing in suitable air and water pollution control equipment.When a firm is considering contingent projects, it is best to consider together all projects that are dependent on one another and treat them as a single project for purposes of evaluation.

Availability of Funds

When a firm has adequate funds to invest in all projects that meet some capital budgeting selection criterion, such as has been true for Philip Morris (now part of Altria Group) in recent years, the firm is said to be operating without a funds constraint. Frequently, however, the total initial cost of the acceptable projects in the absence of a funds constraint is greater than the total funds the firm has available to invest in capital projects.This necessitates capital rationing, or setting limits on capital expenditures, and results in some special capital budgeting problems.

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