On the Problem of Capital Budgeting

Abstract

THE PROBLEM OF CAPITAL budgeting is to decide which of the available investment opportunities a firm should accept and which it should reject. To make this decision rationally, the firm must have an objective. The objective which economists usually assume for a firm is profit maximization. In the traditional short-run theory of the firm, capital is fixed, and the firm seeks to maximize its dollar profits. In the long run the firm can either increase or reduce its investment. It will increase investment if investment brings more than the normal rate of return on invested capital; it will reduce investment if it brings less than the normal return on invested capital; and it will maintain investment if it earns the normal return. This is the same as profit maximization if we recognize that the normal rate of return on invested capital represents a cost rather than a profit. The simple rule of profit maximization can then be applied to any investment project: a project should be accepted only if it adds to the profits of the firm after all costs, including the cost of capital, have been met.In spite of this orientation of traditional theory, recent discussions of the capital-budgeting problem usually assume that the objective is to maximize either (a) the wealth of the owners of the firm or (b) the rate of return that the owners obtain on invested funds. Thus they suggest accepting investment projects which (a) increase the wealth of the owners of the firm or (b) yield a rate of return larger than the normal rate, since the owners would earn the normal rate if they invested elsewhere.The three criteria-profit maximization, wealth maximization, and * I am indebted to many people for helpful comments, criticisms, and suggestions. Special mention must go to Professors Fisher, Segall, Solomon, and Wellisz, although they should not be held in any way responsible for the egregious errors which may remain. 473

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