Mutually Exclusive Projects, Project Sequencing, and Capital Rationing
The cash flow analysis for making capital decisions can become more complex because of the interaction between different projects. The finance manager will have to work with these complexities while evaluating and selecting projects
Independent Vs. Mutually Exclusive Projects
The projects being analyzed by a company may be completely independent of each other or mutually exclusive. When two projects are independent, it means that there cash flows are independent of each other, and so is their profitability. A company may decide to undertake both the projects if they are both profitable.
When two projects are mutually exclusive, it means that the firm wants to undertake only one of these two projects, not both. For example, while deciding between two delivery trucks that have different costs and output, the firm will have to choose one truck between the two.
Sometimes projects can only be executed in a sequence. For example, if three projects A, B and C can be executed in a sequence, then project B can be executed only after project A has been executed. Once the project A has been executed, it creates the opportunity for project B to be executed. The firm will also see if project A has been profitable before going ahead with project B.
Unlimited Funds Vs. Capital Rationing
The company may have unlimited access to capital in which case it can execute all profitable projects simultaneously. However, in reality firms will have constraints on how much funds they have to invest. If there are more capital projects then the funds available, the firm will have to exercise capital rationing and prioritize the projects and first execute those that have the highest impact on shareholder’s value.
- Calculating Net Present Value (NPV) and Internal Rate of Return (IRR) in Excel
- Net Present Value of a Project
- The Capital Budgeting Process
- Principles of Capital Budgeting
- Mutually Exclusive Projects, Project Sequencing, and Capital Rationing
- How to Calculate Payback Period
- How to Calculate Discounted Payback Period
- Calculating Profitability Index of a Project
- Conflict Between NPV and IRR