# Basic Framework for Capital Budgeting - Financial Management

According to economic theory, a firm should operate at the point where the marginal cost of an additional unit of output just equals the marginal revenue derived from the output. Following this rule leads to profit maximization. This principle may also be applied to capital budgeting decisions. In this context, a firm’s marginal revenue is the rates of return earned on succeeding investments, and marginal cost may be defined as the firm’s marginal cost of capital (MCC), that is, the cost of successive increments of capital acquired by the firm. We illustrates a simplified capital budgeting model.

This model assumes that all projects have the same risk. The projects under consideration are indicated by lettered bars on the graph. Project A requires an investment of $2 million and is expected to generate a 24 percent rate of return. Project B will cost$1 million ($3 million minus$2 million on the horizontal axis) and is expected to generate a 22 percent rate of return, and so on. The projects are arranged in descending order according to their expected rates of return, in recognition of the fact that no firm has an inexhaustible supply of projects offering high expected rates of return.

This schedule of projects is often called the firm’s investment opportunity curve (IOC). Typically, a firm will invest in its highest rate of return projects first—such as Project A —before moving on to less attractive alternatives. The MCC schedule represents the marginal cost of capital to the firm. Note that the schedule increases as more funds are sought in the capital markets. The reasons for this include the following:

• Investors’ expectations about the firm’s ability to successfully undertake a large number of new projects
• The business risk to which the firm is exposed because of its particular line of business
• The firm’s financial risk, which is due to its capital structure
• The supply and demand for investment capital in the capital market
• The cost of selling new stock, which is greater than the cost of retained earnings

The basic capital budgeting model indicates that, in principle, the firm should invest \$9 million and undertake Projects A, B, C, D, and E, because the expected returns from each project exceed the firm’s marginal cost of capital. Unfortunately, however, in practice, financial decision making is not this simple. Some practical problems are encountered in trying to apply this model, including the following:

• At any point in time, a firm probably will not know all of the capital projects available to it. In most firms, capital expenditures are proposed continually, based on results of research and development programs, changing market conditions, new technologies, corporate planning efforts, and so on. Thus, a schedule of projects similarly We will probably be incomplete at the time the firm makes its capital expenditure decisions.
• The shape of the MCC schedule itself may be difficult to determine.
• In most cases, a firm can only make uncertain estimates of a project’s future costs and revenues (and, consequently, its rate of return). Some projects will be more risky than others. The riskier a project is, the greater the rate of return that is required before it will be acceptable. In spite of these and other problems, all firms make capital investment decisions. This chapter and the following two chapters provide tools that may be applied to the capital budgeting decision-making process.

Briefly, that process consists of four important steps:

1. Generating capital investment project proposals
2. Estimating cash flows
3. Evaluating alternatives and selecting projects to be implemented
4. Reviewing a project’s performance after it has been implemented, and post-auditing its performance after its termination

The remainder of this chapter is devoted to a discussion of the first two steps.