December 11, 2011

Economics of Capital Budgeting - Joel Dean - Managerial Economics - Review Notes

Joel Dean qualified his treatment of capital budgeting with the statement that the economic analysis of capital budgeting activity is offered tentatively, because capital budgeting has not received adequate attention from economists. The treatment of Joel Dean, focused on economic analytical issues of capital budgeting and procedures and organization of capital budgeting process is not covered in the chapter.

For economic analysis of capital budgeting activity, a capital expenditure should be defined in terms of economic behavior. Capital assets cost the company much above the amount they could be sold for at any point in time and therefore tie up capital inflexibly for long periods.

The capital budgeting problem consists of three questions:

1. How much money will be needed for expenditures in the coming period? Basically this is a demand schedule of the company for capital giving different rates of return?

2. How much money will be available? This is supply schedule at different rates of return demanded by the capital market.

3. How much money should be acquired by the company from the capital market and what projects are to be implemented? This is the allocation and rationing decision.

In this framework, capital budgeting is modeled in the traditional economic framework of demand and supply schedules.

Demand for Capital

The investment proposals from various operating units are invited periodically to determine the demand for capital.  The operation units or departments in production, marketing and service activities have to discover and create profitable opportunities for capital expenditures. The discovery and development of good investment proposals requires continuous and project based efforts. Certain departments specialize in this role. The research and development department creates opportunities in the new products, in improved products, and in improved technology. Industrial engineering department's efficiency and productivity improvement projects provide cost reduction investment projects. Equipment vendors keep developing new equipment and thereby create profitable investment opportunities. Opportunities arise in expansion of marketing channels and even advertising that expands potential market size for the company.

Principles for Measuring Capital Earnings

Capital investments are made because of productivity (rate of return).

1. Recognition of source of capital productivity is essential to correct estimation of it. Generally the most important sources are expected cost savings and growth in sales leading to increased profits.

2. Earnings must be estimated on an individual project basis for the project being proposed.

3. The relevant data of decision is making is future profit which is based on future sales volumes, future prices, future costs etc. The record of the past is useful as a guide or input to estimates of the future.

4. In any decision making situation, alternatives are present. The principle of opportunity cost emphasizes considering at least one alternative to compare with the proposal under consideration and if there are many alternatives, then, it is the best alternative among all other alternatives. The principle of opportunity cost emphasizes the comparison of these two alternatives for right decision making.

5. Effort has to be made for measuring capital productivity over the whole life of the asset, even though the view of the distant future is not very clear.

6. The stream of capital earnings have to be discounted to take account of the diminishing value of distant earnings to terms of today earnings.

7. The amount of capital investment committed to a project is the average capital tied up in the asset ove the period.

8. Estimates of earnings have to take into account the indirect effects of the proposed projects on the operation of existing facilities.

9. There will be tendency in the economic environment to destroy abnormal profit opportunities which are presently available and this risk of profit destruction in the long run should be examined in connection with each profitability estimate.

10. Estimates of future revenues and costs will differ in inherent riskiness and in the width of error margins. Some systematic method for allowing these differences in risk for comparing alternative investments is to be used.

11. Capital productivity measurement is to be emphasized for projects of borderline productivity.  For some projects, quantification may be impractical but  qualitative arguments can be convincing. In some other cases, the loss or revenue by lack of a machine etc. is so evident that estimates of return are more of a formality rather than aid to rational decision making.

Supply of Capital Funds

Supply of capital to a firm consists of internal sources and external sources. The chief internal sources are depreciation and retained earnings. External sources are sale of equity and long-term debt securities to institutions and public.

Capital Rationing

Rejection rates
Cost of capital
Criticism of alternatives to rate-of-return rationing.

Classification of Capital Expenditures

1. Based on source of earnings on capital
2. Based on competitive orientation
3. Based on form of capital asset - plant facility, product improvement, market position etc.
4. Related to technical change - Innovative product, improve product etc.
5. Strategy aspect - two important types of risk reducing and welfare-improving.

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