Abstract

THIS PAPER IS intended to contribute to the theory of capital budgeting by showing, conclusively, that although the cost of capital (as generally defined) is the correct cut-off point for one investment decision, it is not correct when more than one is being considered. When several investments are simultaneously evaluated, the required rate of return should be higher than the cost of capital. The authors propose for the multi-investment case, instead of using the cost of capital as a hurdle rate, the following decision-rule: Rank projects according to their rate of return, then consider each sequentially and accept the project if its contribution to the percentage increase in profits (taking into consideration all previously accepted projects) exceeds the percentage increase in equity capital required for that project.

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