November 30, 2011

Required Rate of Return for Investment or Expenditure Proposal

Engineering Economics Revision Knol Series
Each business expenditure proposal that holds forth prospects of profits can be termed as investment. Investment is defined as spending money with the expectation of profits.

Business firms are users of capital. The user of capital has to satisfy the profit motive of the suppliers of capital. There is cost for using capital.

Introduction - Business Expenditure or Investment

Each business expenditure proposal that holds forth prospects of profits can be termed as investment. Investment is defined as spending money with the expectation of profits.

Deferment of present ability to consume to a future period is done by persons due to profit motive. The profit motive can be explained as the inducement that causes man to forego satisfying his present desires based on the prospects of satisfying greater ones in the future. Thus, every individual is motivated by profit for his personal investment decisions or deferment of consumption decisions. Professional managers of corporations are being paid to perform activities that satisfy the profit motive of the corporation's shareholders.

Cost of Capital and Profit Motive

Business firms are users of capital. The user of capital has to satisfy the profit motive of the suppliers of capital. There is cost for using capital. The cost may be a contractual obligation in case of loans and bonds. It good be a good faith obligation in case of equity capital. The manager is charge of the firm is expected to undertake activities in line with the business plans and execute them to obtain the expected profit.

Sources of Return

Capital is productive. It is continuously invested in fresh investment or expenditure opportunities that yield more profit than the current projects. From this statement, the concept of opportunity cost arises. Whenever any person is contemplating a new expenditure proposal money is being diverted to the new proposal from an old project or currently planned project. The return anticipated from the current project is the floor for the new project. The new project has to give a rate of return that is higher than that of the current selected opportunity. Thus every new proposal has an opportunity cost of capital.

Every proposal that clears the test of opportunity cost of capital is giving profit. Thus owners of capital or professional managers invest their capital in efficient proposals that give profits.

Determination of Cost of Capital

A corporation's capital is sourced from variety of suppliers. Equity Capital, Preferred Share Capital, Profits Retained or Ploughed back and debt capital are the main instruments through which capital is acquired by companies or corporations. To estimate the total cost of capital, the cost of each source of capital is to be first estimated. Then the weight of each source of capital in determined and the weighted average of various costs of capital gives the company cost of capital. This exercise can be done for each proposed project.

Originally posted in
http://knol.google.com/k/narayana-rao/required-rate-of-return-for-investment/2utb2lsm2k7a/1200

No comments:

Post a Comment