What is capital budgeting?
Capital budgeting is a process used by companies for evaluating and ranking potential expenditures or investments that are significant in amount. The large amounts spent for these types of projects are known as capital expenditures.
Capital budgeting usually involves the calculation of each project's future accounting profit by period, the cash flow by period, the present value of the cash flows after considering the time value of money, the number of years it takes for a project's cash flow to pay back the initial cash investment, an assessment of risk, and other factors. Generally : firms are classify investment projects into the following categories.
Replacement : replace equipment which are worn out.
Cost reduction,
Output expansion of traditional products and markets.
Expansion into new products and/or markets.
Government regulation
The evaluation of the worth of long tern investment necessitates a certain nor not standard againist which the benefits are to be judged.There are five reasons which owners and managers of a firm thinks important.
1) Since capital budgeting is long term investment they take form of sinking cost. Therefore cannot be reversed without significant loss of capital
2) The investments are of large sum so it has an impact on profitability is quite significant.
3) Extends beyond the current accounting peiod and cannot be immediately and easily ascertained. 4) Needs vital reputation of
management. Once the capital expenditure is undertaken the capital base on which the profit has to be earned also expands. 5) Has to be on sound
judgement, scientific analysis and product forecasting to help reduce uncertainties and thereby improving profitability.
Methods of investment evaluation
Capital investment analysis is in comparing the benefits that accrue over a period of time with the amount invested.
There are several methods available for making such comparisons.
The common five methods are: 1) The payback period
method.
2) The average return on investment
3) The net present value method.
4) The internal rate of return method.
5) Profitability index criterion. Payback Period
The length of time required to recover the cost of an investment.
All other things being equal, the better investment is the one with the shorter payback period.
There are two main problems with the payback period method:
1. It ignores any benefits that occur after the payback period and, therefore, does not measure profitability. 2. It ignores the time value of money. Because of these reasons, other methods of capital budgeting like net present value, internal rate of return or discounted cash flow are generally preferred.
Accounting Rate of Return - ARR Mean?
ARR provides a quick estimate of a project's worth over its useful life. ARR is derived by finding profits before taxes and interest.
ARR is an accounting method used for purposes of comparison. The major drawbacks of ARR are that it uses profit rather than cashflows, and it does not account for the time value of money.
Net Present value
The difference between the present value of the future cash flows from an investment and the amount of investment. Present value of the expected cash flows is computed by discounting them at the required rate of return.
Internal rate of return method
a. It is the actual rate of return on the investment.
b. It ignores cash flows after the payback period.
c. It is the rate of return which would create a new present value of zero. d. It incorporates the time value of money.
The internal rate of return (IRR) is a way of putting a number to how profitable a potential business enterprise is. It is used to try to compare investment opportunities with very different projected cash flows, to come down to a particular number (IRR) that represents the overall value of each investment considering not simply the amount of money it generates, but the length of the investment. Money earned late in the investment is worth less (in this calculation) than money earned early on, because the money earned early on can be reinvested during the course of the business enterprise.
Profitability Index
Profitability index (PI) is the ratio of investment to payoff a suggested project. It is a useful capital budgeting technique for grading projects because it measures the value created per unit of investment made by the investor.
This technique is also known as Profit Investment Ratio (PIR), Benefit-Cost Ratio and Value Investment Ratio (VIR).
The ratio is calculated as follows:
Profitability Index = Present Value of Future Cash Flows / Initial Investment
If project has positive NPV, then the PV of future cash flows must be higher than the initial investment. Thus the Profitability Index for a project with positive NPV is greater than 1 and less than 1 for a project with negative NPV.
This technique may be useful when available capital is limited and we can allocate funds to projects with the highest PIs.
Decision Rule:
Rules for the selection or rejection of a proposed project: Project should be accepted if Profitability Index > 1and project should be rejected if Profitability Index < 1
WHAT IS COST ANALYSIS?
A cost analysis (also called cost-benefit analysis, or CBA) is a detailed outline of the potential risks and gains of a projected venture. Many factors are involved, including some abstract considerations, making the creation of CBA. It is useful for making many types of business and personal decisions, especially ones with a potential for profit.
THREE TYPES OF COST ANALYSIS IN EVALUATION:
1. Cost allocation , Cost allocation is the process of identifying, aggregating, and assigning costs to cost objects. A cost object is any activity or item for which you want to separately measure costs.
Cost-effectiveness analysis, (CEA) is a form of economic analysis that compares the relative costs and outcomes (effects) of two or more courses of action. Cost-effectiveness analysis is distinct from cost-benefit analysis, which assigns a monetary value to the measure of effect. Cost-benefit analysis A process by which business decisions are analysed. The benefits of a given situation or business-related action are summed and then the costs associated with taking that action are subtracted.
Cost concepts: involving managerial decision in selection between alternative courses of action. Helps in specifying various alternatives in terms of their quantitate values.
Future and past cost: Futurity is an important aspect decision in all business. It estimates the time adjusted in the present and the past. It is reasonably expected to be incurred in some future period/s. Their actual incurrence is a forecast and their management is an estimate.
Incremental and Sunk cost: defined as the change in overall cost that result from a particular decision made. It may include in both fixed and variable cost. It can be avoided by not bringing any change in the activity. It is also called avoidable cost and escapable cost. Difference in total cost resulting from a contemplated cost so called differential cost.
Sunk cost is which is not affected by any altered change or activity and will remain same whatever the level of activity.it is the amortisation of the past expenses.
Out of pocket and Book cost : those that involve immediate payment to outsiders as opposed to book cost that do not require current cash
expenditure.
Book cost can be converted into out of pocket cost by selling assets and leasing them back from the buyer. The difference is that whether the company owns it or not.
Replacement and historical cost.: Historical cost is the cost of the plant, equipment and materials at the price paid originally for them.
Replacement cost means the price that would have to be paid currently for acquiring the same plant.
National income analysis
The national income analyses are an accounting framework used in measuring current economic activity. The national income analyses are based on the idea that the amount of economic activity that occur during a period of time can be measured in terms of:
1.The amount of output produced, excluding output used up in intermediate stages of production (product approach).
2. The income received by the producer of output (income approach); 3.The amount of spending by the ultimate purchase of output (expenditure approach);
National Aggregates: Concepts like GDP, GNP and national income are significant from the view of the macro economy of the country. They provide valuable information about the information of the economy’s health. GNP is the sum of all final goods and services produced by the factors of production – land, labor, capital, and entrepreneurship – of a country during a certain period of time
If all such goods are valued as a price paid to all the factors of production, it is known as GNP at Factor cost. Factors of production earn income in the form of wages, salaries, rent, interest and profits etc. GNP is a flow concept.
GDP, on the other hand, is the total market value of all final goods and services produced during a given period within the boundaries of the country, whether by domestic or foreign-supplied resources. Gross Domestic Product (GDP)a) at market price (MP) b) at factor cost (FC) 2. Gross National Product (GNP) a) at market price (MP) b) at factor cost (FC) 3. Net Domestic Product (NDP) a) at market price (MP) b) at factor cost (FC) 4. Net National Product (NNP) a) at market price (MP) b) at factor cost (FC)
Relationship between Gross & Net; MP & FC; and National & Domestic Concepts Gross = Net + Depreciation Market Prices = Factor Cost + [Indirect Taxes – Subsidies] National = Domestic + Net Factor Income from Abroad
Gross Domestic Product (GDP) at Market Price Less: Indirect taxes Add: Subsidies Gross Domestic Product (GDP) at Factor Cost Add: Net factor income from abroad Gross National Product (GNP) at Factor Cost Depreciation Net National Product (NNP) at Factor Cost (= National Income) Less: (Corporate income tax + Social security contributions) Add: Transfer payments Personal Income Less: Personal taxes Disposable Income
Gross Domestic Product (GDP) at Market Price Less: Indirect taxes Add: Subsidies Gross Domestic Product
(GDP) at Factor Cost Add: Net factor income from abroad Gross National Product (GNP) at Factor Cost Depreciation Net National Product
(NNP) at Factor Cost (= National Income) Less: (Corporate income tax + Social security contributions) Add: Transfer payments Personal Income
Less: Personal taxes Disposable Income
2. a trade practice which is expressly authorised by any law in force.
Pricing methods in practice
There are different types of pricing in the market.
1] Cost based pricing. It has 3 types of pricing. Full Cost or break even pricing. Cost plus pricing and marginal pricing. In the first it includes the total cost. In the second one some mark-up is add to the average cost. Cost oriented pricing is quiet popular. Limitations are difficulties in getting accurate estimates of cost.
2] Simple cost plus pricing: it includes the real cost + arbitrary percentage to cover over heads which leads to profit. The apparent contradiction is that traditional pricing methods often fail. 1] The price of the competing products. 2] The need of maximum loading of production facilities throughout the year. 3] The restraining factors.
3] Profit planning: the method of contribution determining the variable costs and the fixed costs to dictate the market force and still enjoy an extra contribution.
4] Main Application: restraining factors changing according to the company’s activity and circumstances. 5] Penetration Pricing: when entering to new market firms deliberately set a relatively low price in hope of penetration into the market to establish the market share and gradually move to a profitable price.
6] Price Skimming: is a product pricing strategy by which a firm charges the highest initial price that customers will pay. As the demand of the first customers is satisfied, the firm lowers the price to attract another, more price-sensitive segment. 1] loss
leader pricing, 2] transfer pricing, 3] Ramsey pricing
7] Peak load Pricing: used to reduce cost and increase profit if the same facilites are used to provide products or service at different periods. 1] product bundling, 2] prestige/ psychological pricing- perception by charging a higher price on product sold 3] value pricing- selling quality products at lower prices than previously given. 8] Government’s control on pricing: the government controls the pricing from time to time for certain commodities which are mostly necessities
9] Promotional pricing or Discounting: Exchanges, freebies, interest free financing to make a decimal growth in market share.
The MRTP Commission has the following powers:
1. Power of Civil Court under the Code of Civil Procedure, with respect to:
i. Summoning and enforcing the attendance of any witness and examining him on oath;
ii. Discovery and production of any document or other material object producible as evidence;
iii. Reception of evidence on affidavits;
iv. Requisition of any public record from any court or office.
v. Issuing any commission for examination of witness; and
vi. Appearance of parties and consequence of non-appearance.
PRELIMINARY INVESTIGATION
Before making an inquiry, the Commission may order the Director General to make a preliminary investigation into the complaint, so as to satisfy itself that the complaint is genuine and deserves to be inquired into.
Remedies under The Act
The remedies available under this act are-TEMPORARY INJUNCTION
Where, during any inquiry, the commission may grant a temporary injunction restraining such undertaking or person form carrying on such practice until the conclusion of inquiry or until further orders.
COMPENSATION
Where any monopolistic, restrictive or unfair trade practice has caused damage to any Government, or trader or consumer, an application may be made to the Commission asking for compensation, and the Commission may award appropriate compensation.
Where any such loss or damage is caused to a number of persons having the same interest, compensation can be claimed with the permission of the commission, by any of them on behalf of all of them.
Monopoly
A pure monopoly is a single supplier in a market. For the purposes of regulation, monopoly power exists when a single firm controls 25% or more of a particular market.
Formation of monopolies
Monopolies can form for a variety of reasons, including the following:
1. If a firm has exclusive ownership of a scarce resource
2. Governments may grant a firm monopoly
status, such as with the Post Office
3. Producers may have patents over designs, or copyright over ideas, characters, images, sounds or names, giving them exclusive rights to sell a good or service
4. A monopoly could be created following the merger of two or more firms. Given that this will reduce competition, such mergers are subject to close regulation and may be prevented if the two firms gain a combined market share of 25% or more.
characteristics
1. Monopolies can maintain
super-normal profits in the long run. As with all firms, profits are maximised when MC = MR. In general, the level of profit depends upon the degree of competition in the market, which for a pure monopoly is zero. At profit maximisation, MC = MR, and output is Q and price P. Given that price (AR) is
above ATC at Q, supernormal profits are possible (area PABC).
2. With no close substitutes, the monopolist can derive super-normal profits, area PABC.
3. A monopolist with no substitutes would be able to derive the greatest monopoly power.
Monopoly power comes from a firm's ability to set prices. This ability is dictated by the shape of the demand curve facing that firm. If the firm faces a downward sloping demand curve, it is no longer a price taker but rather a price setter. In our perfect competition model, we assume there exist multiple participants, and because there are so many participants, the slice of the demand curve each firm sees is but a flat line. These firms are price takers.
There is a medium between monopoly and perfect competition in which only a few firms exist in a market. None of these firms faces the entire demand curve in the way a monopolist would, but each does have some power to set prices. A small collection of firms who dominate a market is called an oligopoly. A duopoly is a special case of an oligopoly, in which only two firms exist.
Duopolies
We will begin our discussion with an investigation of duopolies. For the following duopoly examples, we will assume the following:
1. The two firms produce homogeneous and
indistinguishable goods.
2. There are no other firms in the market who produce
the same or substitute goods.
3. No other firms can or will enter the market.
4. Collusive behavior is prohibited. Firms cannot act
together to form a cartel.
5. There exists one market for the produced goods.
Cournot Duopoly
In 1838, Augustin Cournot introduced a simple model of duopolies that remains the standard model for oligopolistic
competition. In addition to the assumptions stated above, the Cournot duopoly model relies on the following:
1. Each firm chooses a quantity to produce.
2. All firms make this choice simultaneously.
3. The model is restricted to a one-stage game. Firms
choose their quantities only once.
4. The cost structures of the firms are public
information.
In the Cournot model, the strategic variable is the output quantity. Each firm decides how much of a good to produce. Both firms know the market demand curve, and each firm knows the cost structures of the other firm. The essence of the model is this: each firm takes the other firm's choice of output level as fixed and then sets its own production quantities.
The best way to explain the Cournot model is by walking through examples. Before we begin, we will define the reaction curve, the key to understanding the Cournot model (and elementary game theory as well).
A reaction curve for Firm 1 is a function Q 1 *() that takes as input the quantity produced by Firm 2 and returns the optimal output for Firm 1 given Firm 2's production decisions. In other words, Q 1 *(Q 2) is Firm 1's best response to Firm 2's choice of Q 2 . Likewise, Q 2 *(Q1) is Firm 2's best response to Firm 1's choice of Q 1 .
Let's assume the two firms face a single market demand curve as follows:
Q = 100 - P
where P is the single market price and Q is the total quantity of output in the market. For simplicity's sake, let's assume that both firms face cost structures as follows:
MC_1 = 10 MC_2 = 12
Given this market demand curve and cost structure, we want to find the reaction curve for Firm 1. In the Cournot model, we assume Q 2 is fixed and proceed. Firm 1's reaction curve will satisfy its profit maximizing condition, MR = MC . In order to find Firm 1's marginal revenue, we first determine its total revenue, which can be described as follows
Total Revenue = P * Q1 = (100 - Q) * Q1 = (100 - (Q1 + Q2)) * Q1
= 100Q1 - Q1 ^ 2 - Q2 * Q1
The marginal revenue is simply the first derivative of the total revenue with respect to Q 1 (recall that we assume Q 2 is fixed). The marginal revenue for Firm 1 is thus:
MR1 = 100 - 2 * Q1 - Q2\
Imposing the profit maximizing condition of MR = MC , we conclude that Firm 1's reaction curve is:
100 - 2 * Q1* - Q2 = 10 => Q1* = 45 - Q2/2
That is, for every choice of Q 2 , Q 1 * is Firm 1's optimal choice of output. We can perform analogous analysis for Firm 2 (which differs only in that its marginal costs are 12 rather than 10) to determine its reaction curve, but we leave the process as a simple exercise for the reader. We find Firm 2's reaction curve to be:
Q2* = 44 - Q1/2
The solution to the Cournot model lies at the intersection of the
two reaction curves. We solve now for Q 1 * . Note that we
substitute Q 2 * for Q 2 because we are looking for a point which lies on Firm 2's reaction curve as well.
Q1* = 45 - Q2*/2 = 45 - (44 - Q1*/2)/2 = 45 - 22 + Q1*/4
= 23 + Q1*/4 => Q1* = 92/3
By the same logic, we find:
Q2* = 86/3
Again, we leave the actual computation of Q 2 * as an exercise for the reader. Note that Q 1 * and Q 2 * differ due to the difference in marginal costs. In a perfectly competitive market, only firms with the lowest marginal cost would survive. In this case, however, Firm 2 still produces a significant quantity of goods, even though its marginal cost is 20% higher than Firm 1's.
An equilibrium cannot occur at a point not in the intersection of the two reaction curves. If such an equilibrium existed, at least one firm would not be on its reaction curve and would therefore not be playing its optimal strategy. It has incentive to move elsewhere, thus invalidating the equilibrium.
The Cournot equilibrium is a best response made in reaction to a best response and, by definition, is therefore a Nash equilibrium. Unfortunately, the Cournot model does not describe the dynamics behind reaching equilibrium from a non-equilibrium state. If the two firms began out of equilibrium, at least one would have an incentive to move, thus violating our assumption that the quantities chosen are fixed. Rest assured that for the examples we have seen, the firms would tend towards equilibrium. However, we would require more advanced mathematics to adequately model this movement.
Stackelberg duopoly
The Stackelberg duopoly model of duopolies is very similar to the Cournot model. Like the Cournot model, the firms choose the quantities they produce. In the Stackelberg model, however, the firms do not move simultaneously. One firm holds the
privilege to choose production quantities before the other. The assumptions underlying the Stackelberg model are as follows:
1. Each firm chooses a quantity to produce.
2. A firm chooses before the other in an observable
manner.
3. The model is restricted to a one-stage game. Firms
choose their quantities only once.
Bertrand Duopoly
The Bertrand duopoly Model, developed in the late nineteenth century by French economist Joseph Bertrand, changes the choice of strategic variables. In the Bertrand model, rather than choosing how much to produce, each firm chooses the price at which to sell its goods.
1. Rather than choosing quantities, the firms choose the
price at which they sell the good.
2. All firms make this choice simultaneously.
3. Firms have identical cost structures.
4. The model is restricted to a one-stage game. Firms
choose their prices only once.
The Bertrand Model differs from the Cournot model only in the strategic variable, the two models yield surprisingly different results. Whereas the Cournot model yields equilibriums that fall somewhere in between the monopolistic outcome and the free market outcome, simply reduces to the competitive equilibrium, where profits are zero. Rather than go through a series of convoluted equations to derive this result, to show there could be no other outcome. It is the no profit equilibrium.
Demand Forecasting
it can be used to forecast demand conditions in future time periods.
Qualitative Forecasting Techniques
Qualitative forecasting involves combining the available data with a heavy dose of expert opinion about the firm and industry, assigning subjective weights to these pieces of evidence. Qualitative forecasting is complex and not easily replicated. It is difficult to teach qualitative forecasting techniques because the subjective or judgment component of the forecast depends upon the experience and knowledge of the forecaster
Seasonal (or Cyclical) Variation. Time-series data may frequently exhibit regular, seasonal, or cyclical variation over time, and the failure to take such regular variation into account when estimating a forecasting equation would bias the forecast. When data exhibit cyclical variation, such as seasonal patterns, dummy variables can be added to the time-series model to account for the seasonality.
l A dummy variable is a variable that takes only values of 0 and 1.
l Correcting for seasonal variation by using dummy variables: If there are N seasonal time periods to be accounted for, N-1 dummy variables can be added to the demand equation. Each dummy variable accounts for one of the seasonal time periods. The dummy variable takes a value of 1 for those observations that occur during the season assigned to that dummy variable and a value of 0 otherwise.
Dummy variables are used: (equal to 1 in the ith season and 0 otherwise),
This type of dummy variable allows the intercept of the demand equation to take on different values for each season— the demand curve can shift up and down from season to season. 8.4 Econometric Models
. Econometric models use an explicit structural model to explain the underlying economic relations. If we wish to employ an econometric model to forecast future sales, we must develop a model that incorporates the variables that actually determine the level of sales (e.g., income, the price of related goods, and so on). This approach differs from the qualitative approach, in which a loose relation was posited between sales and some leading indicators, and the time-series approach, in which sales are assumed to behave in some regular fashion over time. l Advantages of using econometric models
Ø This approach requires analysts to define explicit causal relations. This specification of an explicit model helps eliminate problems such as spurious (false) correlation between normally unrelated variables and may make the model more logically consistent and reliable.
Ø This approach allows analysts to consider the sensitivity of the variable to be forecasted to changes in the exogenous explanatory variables. Therefore, the analyst can examine the behavior of these variables more closely.
Econometric forecasting can be utilized to forecast either future industry price and quantity for price-taking firms or future demand for a price-setting firm.
l Forecasting future industry demand and supply for price-taking firms
Ø Estimate the industry demand and supply equations (was introduced in chap.7);
Ø Locate industry demand and supply in the forecast period;
Ø Calculate the intersection of future demand and supply.
l Forecasting future industry demand and supply for price-setting firms
Ø Estimate the firm’s demand function (was introduced in chap.7);
Ø Forecast the future values of the demand-shifting variables
