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Several project interactions make the incremental cash flow analysis very challenging for analysts. Specifically, the evaluation of capital projects, as well as their selection, may be greatly affected by the extent to which there are mutually exclusive projects and project sequencing and capital rationing occur.
Mutually Exclusive Projects
Mutually exclusive projects are capital projects which compete directly with each other. For example, if a manager has to make a choice strictly between undertaking either project X or Y, but not both of them concurrently, then projects X and Y are said to be mutually exclusive. This scenario differs from independent projects. These are projects whose cash flows are independent of each other and can, therefore, be undertaken concurrently.
Project Sequencing
The purpose of project sequencing is to arrange projects in a logical order for completion. It enables a project manager to determine the order in which projects are completed. Indeed, project sequencing helps in proper and effective management of the available time and resources.
Through project sequencing, investing in one project may create room for investment in future projects. For example, a manager may invest in one project today and then invest in another project in a year depending on the returns from the first project or if new economic conditions are favorable.
Capital Rationing
Capital rationing is the act of placing restrictions on the amount of new investments or projects that a company can undertake. It may occur either through the imposition of a higher cost of capital for investment consideration or by the imposition of an investment budget ceiling.
Capital rationing is more frequent whenever a company has a fixed amount of funds available for investment. However, if the number of profitable projects a company wishes to invest in exceeds the available funds, then the company will be forced to allocate these scarce funds in a manner that achieves maximum shareholder value subject to the funding constraints.
The opposite of capital rationing occurs whenever a company has unlimited funds. In this situation, a company can raise the required funds for all profitable projects simply by paying the required rate of return.
Question
Which of the following is an accurate example of mutually exclusive projects?
A. A manager can choose to invest in both projects A and B at the same time.
B. A manager can choose between investing in either project A or B, but not both.
C. A manager can choose to invest in project A first and then invest in project B shortly after the start of project A.
Solution
The correct answer is B.
Option B accurately describes two mutually exclusive projects.
A and C are incorrect because in both instances, two projects being invested in concurrently. Once two projects are mutually exclusive, you cannot invest in both at the same time.
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2021-07-23
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2021-07-17
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