Economics 373

MANAGERIAL ECONOMICS
Spring 2015
 
| HOME | SYLLABUS | CALENDAR | ASSIGNMENTS | ABOUT PROF. GIN |
 

III.  More Decision Making Tools

A.  Capital Budgeting

  • Process of planning expenditures that give revenues or returns over a number of years

1.  Categories of investment projects

a.  Replacement

  • Replace equipment that is worn out

.

b.  Cost reduction

  • Replace obsolete equipment with new and more efficient equipment

.

c.  Output expansion of traditional products and markets

  • Expand production facilities due to increased demand

.

d.  Expansion into new products and/or markets

  • Develop, produce, and sell new products and/or enter new markets

.

e.  Government regulation

  • Investments made to comply with government regulations on health, safety, pollution control, and other legal requirements

.

2.  Capital budgeting process

.

.

.

.

.

.

.

.

.

a.  Projecting cash flows

  • Guidelines

(1)  Should be measured on an incremental basis

(2)  Should be done an after-tax basis

(3)  Depreciation is a noncash expense

  Year 1 Year 2 Year 3 Year 4 Year 5
Sales less: $1,000,000 $1,100,000 $1,210,000 $1,331,000 $1,464,100

Variable costs

 500,000 550,000 605,000 665,500 732,050

Fixed costs

 150,000 150,000 150,000 150,000 150,000

Depreciation

 200,000 200,000 200,000 200,000 200,000
Profit before taxes $150,000 $200,000 $255,000 $315,500 $382,050
Less: Income tax 60,000 80,000 102,000 126,200 152,820
Profit after tax $90,000 $120,000 $153,000 $189,300 $229,230
Plus: Depreciation 200,000 200,000 200,000 200,000 200,000
Net cash flow $290,000 $320,000 $353,000 $389,300 $429,230

b.  Net present value

  • Discounted net cash flows from a project

.

.

.

.

.

c.  Internal rate of return (IRR)

  • Discount rate that equates present value of present value of net cash flows to the initial cost

.

.

.

.

  • Take on project if IRR > marginal cost of capital

.

d.  Profitability index

  • Used if capital rationing is required

- Strain on managerial, personnel, and other resources of a firm if all positive NPV projects taken on

- Reluctance to borrow

- May have arbitrary limits on capital budgets of various divisions

.

.

.

.

.

3.  Cost of capital

 

a.  Cost of debt

  • Return lenders require to lend funds to a firm

.

.

.

.

.

.

b.  Cost of equity capital

  • Returns stockholders require to invest in a firm

.

(1) Risk-free rate plus premium

  • Add risk premium to risk-free rate

.

.

.

.

.

(2)  Dividend valuation model

  • Value of stock is equal to present value of all future dividends

.

.

.

.

  • Suppose dividends expected to grow at constant rate over time

.

.

.

.

.

.

(3)  Capital asset pricing model  (CAPM)

  • Takes riskiness of asset into consideration

.

.

.

.

c.  Weighted cost of capital

  • Composite cost of capital - weighted average of the cost of debt capital and equity capital

.

.

.

.

4.  Other considerations

a.  Reviewing investment projects after implementation

  • Compare actual cash flow and return with expected cash flow and return

.

b.  Cost of capital and international competitiveness

  • Higher nominal and real interest rates in the U.S. in reduced competitiveness of U.S. firms