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Keeping managers in line
Chapter 16: Using Capital Budgeting to Prepare for the Future
In determining whether or not to invest in a project, you still maximize profits. To accomplish this goal, you undertake all investment projects that have marginal revenue exceeding marginal cost (MR>MC). In capital budgeting, the investment’s rate of return represents marginal revenue, while the firm’s cost of capital represents marginal cost.
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Figure 16-1 illustrates the capital budgeting process. The investment return curve, IR, represents the anticipated return on various investment projects. The curve is disjointed, reflecting the different sizes and returns for various projects. For example, project A requires a $10 million investment and yields an expected 18-percent rate of return. Project B requires a $30 million investment — increasing the total capital investment to $40 million — and yields an expected 15-percent return. The downward tendency of the curve indicates that you undertake investment projects with highest expected return first.
The investment return curve in Figure 16-1 is disjointed, reflecting the fixed investment required for each project. Thus, project A requires a $10 million investment — a partial investment can’t be made.
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Figure 16-1: Investment selection process.
The cost of capital curve, CC, indicates the marginal cost of obtaining each additional investment dollar. In Figure 16-1, this curve is horizontal until $30 million, representing a constant cost of capital at 8 percent. After $30 million, the curve slopes upward, indicating rising cost associated with the firm’s increasing debt load.
