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[2]
Chapters Contents of Unit I Pages
No. Nos.
1 Managerial Economics / Business Economics 3-32
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CHAPTER 1
MANAGERIAL ECONOMICS / BUSINESS ECONOMICS
Managerial Economics:
It essentially constitutes of economic theories and analytical tools that are widely applied to business
decision-making. Therefore to understand the concept of managerial economics it is important to know “what is
economics”?
“Economics is a social science which studies how people – individuals, households, firms and nations –
maximise their gains from their limited resources and opportunities i.e., maximising behaviour or optimizing
behaviour of the people”.
In other words, economics is a social science which studies human behaviour in relation to optimizing
allocation of available resources to achieve the given ends.
[4]
Scope of Managerial Economics:
Economics has two major branches:
1. Microeconomics
2. Macroeconomics
Both these economics are applied to business analysis and decision making. The areas of business issues to
which economic theories can be directly applied may be broadly divided into two categories –
a) Microeconomics applied to operational or internal issues.
b) Macroeconomics applied to environmental or external issues.
[5]
B. Issues Related to Foreign Trade:
Since the managers of a firm are interested in knowing the trends in international trade, prices and exchange
rate and prospects in international market. This can be studied, obtained from international trade and
monetary mechanism branch of macroeconomics.
Definition:
According to Marshall in his book “Principles of Economics”- “Economics is the study of mankind
in the ordinary business of life; it examines that part of individual and social action which is most closely
connected with the attainment and with the use of the material requisites of well –being”.
According to Robbins in his book “Nature and Significance of Economic Science” (1931)
Economics is the science which studies human behaviour as a relationship between ends and scarce means
which have alternative uses”.
The subject – matter of economics is so broad that that the study of economics has been divided into
two parts:
1. Micro Economics
2. Macro Economics
Micro Economics
vs.
Macro Economics
These terms were coined by Ragnar Frisch.
According to K.E. Boulding “Micro Economics is the study of particular firms, particular
households, individual prices, wages, incomes, national industries, particular commodities”.
“Macro Economics deals not with individual quantities as such but with aggregates or these
quantities not with individual incomes but with the national income; not with individual prices but with
the price levels; not with individual outputs but with the national output”.
Micro-Economic Theories
Product Pricing Factor Pricing Theory of Economic Welfare
(Theory of Distribution)
……………….
[6]
Chapter - 2
Production Function
Production is the transformation of physical inputs into physical outputs. It is creation or addition of
value. The theory of production provides a framework to help the managers to decide how to combine various
factors or inputs most efficiently to produce the desired output or service.
The relation between input and output of a firm has been called “The Production function”. Therefore,
the theory of production is the study of production functions.
Production function can be of two types:-
1) Short-run production function
2) Long-run Production function
Definition:
The law of variable proportions states that as the quantity of a variable input is increased by equal
doses keeping the quantities of other output constant, total product will increase, but after a point at diminishing
rate.
In other words:
When more and more units of the variable factor are used, holding the quantities of fixed factors
constant, a point is reached beyond which the marginal product, then, the average and finally the total product
will diminish.
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The Law of variable proportion is also known as the law of diminishing returns
To understand this law following concepts must be very clear.
1. Total product.
2. Marginal product
3. Average Product
4. Output elasticity of an input.
Example
MP Output Elasticity
Labour TP
L Q of labour (EL)
1 80 80 80 1
2 170 90 85 1.05
3 270 100 90 1.11
4 368 98 92 1.06
5 430 62 86 0.72
6 480 50 80 0.62
7 504 24 72 0.33
8 504 0 63 0
9 495 -9 55 -0.16
10 480 -15 48 -0.13
Labour – represent the number of workers
TP – Total Product
MP – Marginal product
AP - Average Product
EL - Output Elasticity of labour
1. Total Product:
The total product of a variable factor is the amount of total
output produced by a given quantity of the variable factor, keeping
the quantity of other factors such as capital, fixed., as the amount of
variable increases, the total output increases. But the rate of increase
in total output varies at different levels of employment of the
variable factor. It will be seen in the table that as more workers are
employed with a given quantity of capital, the total output of the
product (TP) increases.
2. Marginal Product:
Marginal Product of a variable factor is the addition made tot eh
total production by the employment of an extra unit of a factor.
Eg. When two workers are employed to produce the product they
produce 170 units. Now, if instead of two workers, three
workers are employed and as a result total product increases to
270 i.e, the third worker has added 100 meters to the total
production. Thus the marginal product of the third worker is 100
unit.
In general, if employment of labour increases by units
yielding increases in total output by units, the marginal
product of labour is given by MPL =
3. Average Product:
Average Product of a variable factor (labour) is the total output (Q) divided by the amount of labour
employed with a given quantity of capital (the fixed factor) used to produce commodity.
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APL =
The law of variable proportions is presented diagrammatically in the figure. The TP curve first rises at
an increasing rate upto point B where its slope is the highest.
From point B upwards, see the total product increases at a diminishing rate till it reaches its highest
point C and then its starts falling. The maximum point on AP curve is E where it coincides with point B on the
TP curve from where the total product starts a gradual rise. When the TP curve reaches its maximum point C,
the MP curve becomes zero at point F.
Where TP curves starts declining the MP curves become negative. It is only when the total product
declines the marginal product becomes zero.
The rising, the falling and the negative phase of the total, marginal and average products are infact the
different stages of the law of variable proportions.
= x = .
Since, represents MP of labour and represents average product of labour the equation can be
written as EL = .
The output elasticity of labour is the ratio of marginal product of labour to its average product.
When the elasticity of production of a variable input being less than one indicates diminishing returns
to that factor.
When the production elasticity is zero means that output does not change at all when a given
percentage change in a variable input. Keeping other factors constant, is used in the production process.
If or when elasticity of production is less than zero (that is, it is negative), this implies that output of the
commodity decreases as a result of a given percentage increase in the variable input.
………………………
[9]
CHAPTER – 3
COST OUTPUT RELATION
Cost of Production:
When the input are multiplied by their respective prices and added together, they give the money value
of the inputs, i.e., the cost of production.
Cost of production is an important factor in almost all business analysis and business decision-making.
Cost Concepts:
The cost concepts are divided into two parts –
1. Accounting cost concept
2. Analytical cost concept.
Analytical Cost
1. Fixed and Variable Costs:
Fixed costs are those that are fixed in volume for a certain quantity of output. It does not vary with
variation in the output between zero and a certain level of output.
It includes:
a) Costs of managerial and administrative staff.
b) Depreciation of machinery, building and other fixed assets.
c) Maintenance of land etc.
The concept of fixed cost is associated with the short-run.
Variable cost are those costs which vary with the variation in the total output. Variable costs include cost of
raw material, running cost of fixed capital such as fuel, repairs.
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2. Total, Average and Marginal Costs:
Total cost is the total actual cost incurred on the production of goods and service. It refers to the total
outlays of money expenditure, both explicit and implicit, on the resources used to produce a given level of
output. It includes both fixed costs and variable costs.
Average cost is of statistical nature. It is obtained by dividing the total cost (TC) by the total output (Q) i.e.,
AC =
Marginal cost is defined as the addition to the total costs on account of producing one additional unit of the
product. It is the cost of the marginal unit produced. It is calculated as TCn – TCn-1 where n is the number
of units produced.
MC =
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Short-Run Cost-Output Relations
The basic analytical cost concepts used in the analysis of cost behaviour are total, average and marginal
costs.
Total Cost
The total cost (TC) is defined as the actual cost that must be incurred to produce a given quantity of output. The
short-run TC is composed of major two elements:
i. Total fixed cost (TFC)
ii. Total Variable cost (TVC)
TC = TFC + TVC
TFC (i.e., the cost of plant, building, etc) remains fixed in the short-run, whereas, TVC varies with the
variation in the output.
For a given quantity of output (Q), the average cost, (AC), average fixed cost (AFC) and average
variable cost (AVC) can be defined as follows:
AC = =
= + = AFC + AVC
Thus,
AFC = and AVC =
and
AC = AFC + AVC
Marginal cost (MC) is defined as the change in the total cost divided by the change in the total output,
i.e.,
MC =
In fact,
MC is the first derivative of cost function ie.,
It may be added here that since = and in the short-run therefore,
. Furthermore, under the marginality concept, where MC = .
Where TC = total cost, Q = quantity produced, a = TFC and b = change in TVC due to change in Q.
Given the cost function in equation 1, AC and MC can be obtained as follows:
AC = = = + b and MC =
Since, ‘b’ is a constant, MC remains constant throughout in case of a linear cost function.
Eg. to illustrate a linear cost function, let us suppose that an actual cost is given as
TC = 60 + 10Q - Eq. 2
Given, the above cost function, one can easily work out TC, TFC, TVC, MC and AC for different
levels of output.
……………..
[12]
CHAPTER 4
MARKET STRUCTURE AND PRICING THEORIES
Depending on the number of sellers and degree of competition, the market structure is broadly
classified as follows:
Large number of
firms with Financial markets
1. Perfect Market exchange
homogenous and some farm None
Competition or auction
products products
2. Imperfect competition
Many firms with Manufacturing
real or perceived Competitive
a) Monopolistic tea, toothpastes,
product Some Advertising,
competition TV sets, shoes
differentiation Quality Rivalry
refrigerators, etc.
Little or no. of Aluminium, steel Competitive
b) Oligopoly product cars, passenger Some advertising quality
differentiation cars etc. rivalry
A single products Public utilities, Promotional
Considerable but
c) Monopoly without close telephones, advertising if
usually regulated
substitute electricity etc. supply is large
The market structure determines a firm’s power to fix the price of its product a great deal.
The degree of competition determines a firm’s degree of freedom in determining the price of its
product. The higher the degree of competitions the lower the firm’s degree of freedom in pricing
decision and control over the price of its own product and vice-versa.
Perfect Competition:
In this type of market structure a large number of firms compete against each other for selling
their product. Therefore the degree of competition under this is close to one i.e., market is highly
competitive firm’s discretion in determining the price of its product is close to none. In fact, the price
is determined by market forces i.e, demand and supply.
Monopolistic competition:
Degree of competition is high but less than one, i.e., the firm’s have some discretion in
setting the price of their products. The degree of freedom in monopolistic competition depends
largely on the number of firms and the level of product differentiation.
Oligopoly:
The control over the pricing discretion increases under oligopoly where degree of competition
is quite low, lower than that under monopolistic competition.
Monopoly:
The degree of competition is close to nil. Monopoly firm has full control over the price of its
product. It is free to fix any price for its product, of course under certain constraints, viz. i) the
objective of the firm and ii). Demand conditions.
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Price Determination Under Perfect Competition
Characteristics:
1) A large number of sellers and buyers,
2) Homogeneous product
3) Perfect mobility of factors of production
4) Free entry and free exit of firms
5) Perfect knowledge
6) Absence of collusion or artificial restraint
7) No government intervention.
Similarly, given the demand for a product, if its supply decreases suddenly for such reasons as
droughts, floods etc price of the products will shoot up as shows in the figure.
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Price – Determination In the Short-Run:
A short-run is, by definition a period in which firms can, neither change their scale of
production pr quit, not can new firms enter the industry. While in the market period supply is
absolutely fixed; in the short-run, it is possible to increase (or decrease) the supply by increasing (or
decreasing) the variable inputs.
The determination of market price in the short-run is explained in the diagram (a) and
adjustment of output by firms to the market price and firm’s equilibrium are shows in figure (b).
Given the price P1Q in figure (a) firms are required to adjust their output to the price PQ so
that they maximise their profit.
The process of firm’s output determination is shown in figure (b). since price is fixed at PQ,
firm’s AR = PQ. If AR is constant, MR = AR. The firm’s MR is shown by AR = MR line. Firms
upward sloping MC curve intersect AR = MR at E. at point E, MR = MC. Point E is therefore firm’s
equilibrium. Therefore the profit – maximising output is OM.
The total maximum Profit has been shown by the area P1TNE.
Profit = (AR – AC).Q
AR = EM
AC = NM
Q = OM
Substituting these values we get
Profit = (EM – NM).OM
= EN x OM
= P1TNE.
P1TNE is maximum supernormal profit or economic profit given the price and cost curves, in
short run.
Firms may make losses in the short-run.
While firms may make supernormal profit, there may be conditions under which firms make
losses in the short-run this may happen if market price decreases to P’Q’ due to downward shift in the
demand curve from DD to D’D’ (a). This will force a process of output adjustments till firms reach a
new equilibrium at point E’. Here again firm’s AR’ = MR’ = MC.
But in Figure (b) AR <AC. Therefore firms incur loss. But the firms will survive in the
short-run so long as they cover their MC.
…………………….
[15]
CHAPTER 5
MACRO-ECONOMICS
Introduction:
Macro Economics emerged as a separate branch in 1936 with the publication of’ John Maynard
Keynes’ book, “The General Theory of Employment, Interest and Money, generally referred to as The General
Theory.
Definitions:
P.A. Samuelson defined “Macro economics is the study of the behaviour of the economy as a whole.
It examines the overall level of a nation’s output, employment, prices and foreign trade”.
Kenneth E Boulding defined “Macroeconomics is the study of the nature, relationship and behaviour
of aggregates of economic quantities. Macroeconomics deals not with individual quantities as such, but with
aggregates of these quantities – not with individual incomes, but with the national income, not with individual
prices, but with price levels, not with individual output, but with the national output”.
Thus, from the above definitions we can say that Macroeconomics is a study of economic system as a
whole. It deals with aggregate national income, total consumption of goods and services, total savings and
investment, unemployment, inflation etc, in the economy. It concentrates on the equilibrium of the entire
economy. It is also known as the theory of income and employment. It is concerned with the problems of
unemployment, economic fluctuations, inflation, deflation, instability, stagnation, international trade and
economic growth. It is the study of the causes of unemployment, and the various determinants of employment.
In the field of business cycles, it concerns itself with the effect of investment on total output, total
income, and aggregate employment. In the monetary sphere, it studies the effect of the total quantity of money
on the general price level.
In international trade, the problems of balance of payments and foreign aid fall within the purview of
macro-economic analysis above all, macroeconomic theory discusses the problems of determination of the total
income of a country and causes of its fluctuations. Finally, it studies the factors that retard growth and those
which bring the economy on the path of economic development.
Macro-Economic Theories
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i. Classical Macroeconomics
ii. Keynesian Revolution
iii. Post-Keynesian Developments
The great Depression of 1930s, however, proved all the classical postulates wrong. It exposed the
inadequacy of the theoretical foundations of the classical laissez-faire doctrine’. The classical economics could
offer neither an explanation nor a solution to the economic problem created by the Great Depression. Therefore,
this necessitated a fresh look at the working of the economic system. Hence the emergence of the Keynesian
Macroeconomics took place.
The dominance of the Keynesian postulates banished the classical view for some time, at least. The
period between the late 1930s and Mid 1960s is called the period of “Keynesian Revolution”. During this
period most economists and governments had adopted Keynesian policies.
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national output, not the role of aggregate demand for real output as Keynesian’s believed. According to
monetarists money supply is the main determinant of output and employment in the short run and price
level in the long run.
The monetarists added a new dimension to both macroeconomic theory and policy. At theoretical
level, the emphasis shifted from the analysis of the role of aggregate demand fro real output to the
aggregate demand for and supply of money and at policy level, the emphasis shifted from demand
management to monetary management.
The monetarists view led to a prolonged debate between the monetarists and Keynesians about –“what
determines the aggregate demand”.
(iv) Neo-Keynesians:
Keynesian economics remains the focal point of reference for all the schools of macroeconomists either
for attack or for its reconstruction. In the process, an another school of thought emerged which was known
as “Neo-Keynesians”.
Neo-Keynesians argue that market does not clear always, in spite of individuals (household, firms and
labour) working for their own interest. They give reason that information, problem and cost of changing
prices lead to some price rigidities which cause fluctuations in output and employment.
…………………..
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CHAPTER – 6
The market value of domestic product is obtained at both constant and current prices. Accordingly, GDP is
known as ‘GDP at constant prices’ and ‘GDP’ at current prices”, respectively.
GDP can also be defined and measured as the sum of all factor payments (wages, interest, rent, profit and
depreciation). It is then called ‘GDP at factor cost’.
5. Disposable Income:
Disposable Income refers to personal income of the income earners against which they do not have any legally
enforceable payment obligations eg. income tax, fine and penalties etc.
Disposable – Personal Income – (income tax + fees + fines)
6. Private Income:
Broadly speaking, all personal incomes are private incomes. However, the term private income is used in
contrast to public income for the purpose of national income accounting, NNP is generally divided into two
parts:
1. Private income, and
2. Public income. Public income is that part of NNP which accrues to the public sector, including
administrative units of the government and the government commercial undertakings. Thus, income
accruing to the public sector is called public income. In contrast, incomes accruing to the individuals,
[19]
including private sector earnings, transfer payments and undistributed profit of private companies are called
personal income.
1. GNP at factor cost +Net Indirect taxes – Depreciation = GNP at market prices
2. GNP at market price – depreciation = NNP at market price
3. NNP at market price – Indirect taxes + subsidies = NNP at factor cost
4. NNP at factor cost + /- domestic income accruing to non-residents = NDP at factor cost
5. Personal Income – Direct taxes, fees, fines, etc = Disposable Income
6. NDP at factor cost – surplus of public undertakings – rentals / profits of = Personal income
statutory corporations – profit tax – income accruing to non residents +
interest on national debt + transfer payments
The GNP, and also GDP, are estimated at both current and constant prices. The GNP estimated at current prices
is called nominal GNP and GNP estimated at constant price in a chosen year (called ‘base year’) is called real
income. Similarly, GDP estimated at current prices and constant prices is called nominal GDP and real GDP
respectively.
The GNP deflator is essentially an adjustment factor used to convert nominal GNP into real GNP.
The GNP deflator is the ratio of price index number (PIN) of a chosen year to the price index
number(PIN) of the base year. The PIN of the base year = 100. The chosen year is the year who real GNP is to
be estimated.
The formula for converting nominal GDP of a year into real GNP may be written as follows.
Real GNP =
or
Real GNP=
The GNP implicit deflator can be used for the following purposes:-
i) To construct price index number, and
ii)To measure the rate of change in prices, i.e, to measure the rate of inflation or deflation.
[20]
Methods of Measuring National Income
The economists have, devised different methods of estimating national income. The basic approach in
measuring national income is to measure the two kinds of flows generated by the economic activities of the
residents of the country. The circular flows of income the income generating process creates two kinds of
flows:
a) Product flows.
b) Money flows
The money flows can be looked upon from two angles
a) The money flows as factor payments.
b) Money flows as payments for goods and services.
Given the product flows and two ways of money flows, the economists have devised three methods of
measuring national income.
…………………
[21]
CHAPTER 7
BUSINESS ENVIRONMENT
Business:
Business is an economic activity performed by business firms or organisations often with the
objectives of maximising profit. This objective is supplemented by other objectives such as sales
maximisation, growth maximisation, maximisation of market share, maximisation of own benefits by
the managers, building up an image, and social responsibility. The economic activities performed by
business organisations include production (transformation of inputs into outputs), distribution (supply
of output in a marketplace) and sales (exchange of products with buyers for money).
Profit Maximisation:
Profit maximisation which is one of the main objectives of business organisations, requires
maximisation of revenue. However, resources in the hands of business organisations are limited.
Therefore, firms face the challenge of allocating existing resources among alternative uses in such
process of allocation and profit maximisation.
Types of Environment:
1. Micro Environment:
The micro business environment, also known as task environment, refers to the immediate
surroundings of the business. It not only affects the operations of the firm but also gets
influenced by its decisions and actions.
“The micro environment consists of the actors in the company’s immediate environment that
affects the performance of the company. These include the suppliers, marketing
intermediaries, competitors, customers and the public’s.”
1. Public:
It consists of all those parts of society which can directly or indirectly influence an organisation’s
ability to achieve its objectives. Public opinion is important for a company as it can either
strengthen or weaken its brand image. For example, satisfied customers are a public that spread
good image about the products through word of mouth. On the contrary, activist, consumer
forums, non-government agencies and even media protesting against the environmental damage
done by a company is a public that can tarnish the image of a company, and weaken its brand
image. Thus, managing public opinion is a crucial task for any company.
2. Suppliers:
They are the agents who supply inputs, such as raw materials and intermediate goods to an
organisation. They play an important role in operational efficiency. A delay in the supply of
inputs can delay all the subsequent operations and the firm may fail in timely delivery of its
products to customers, resulting in consumer dissatisfaction and even losing them forever.
Therefore, managers need to assess the ability of suppliers for their ability to supply inputs in the
required quantities in a given time frame.
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4. Competitors:
Competitors are rivals who compete with an organisation in the market place. Except monopoly
market structure, firms in all other market structures have one or more competitors for their
products. As the number of competitors increases the competition becomes intense. Competitors
not only compete for customers but also for talented staff. To prevent customers and employees
from shifting to the competitors, a company needs to continuously assess consumer taste and
preferences, and design the products accordingly. It also needs to design retention strategies so
that the talented staff can be retained for a longer time.
5. Market Intermediaries:
Marketing Intermediaries consists of service agencies and financial intermediaries. Service
agencies include marketing research and consultancy firms, advertising agencies and media firms.
These agencies help consumers identify the target population and market products in most
efficient and influential manner.
6. Consumers:
Consumers comprise individuals and households that buy goods and services for personal
consumption. Consumers are the most important constituents of the micro business environment
as they are the demand side of the market. Without them companies cannot do their business?
Identifying customer needs, retaining customers, and extending products and services to them
throughout their lives are important challenges for business organisations.
2. Macro Environment:
Macro business environment refers to the general environment. It though influences
business decisions, is not affected by the functioning of a business unit, making it an
uncontrollable factor.
The macro environment consists larger societal forces that affect all the actors in the
company’s micro environment – namely, the demographic, economic, natural, technical,
political and cultural forces.”
b. Culture:
Derived mostly from the climatic conditions of the geographical region and economic conditions
of the country.
A set of traditional beliefs and values which are transmitted and shared in a given society
A total way of life and thinking patterns that are passed from generation to generation.
Norms, customs, art, values etc.
Technological Environment:
A given set of technologies available for the conduct of business determines the technological
environment of business. Technology is the application of science, art and other fields of
knowledge in various activities such as designing tools and equipments, producing goods and
supplying services, communicating information and enhancing productivity.
Technological advancements are driving force behind the global developments for centuries, but
they are much more rapid in the present era, making the global environment highly dynamic and
challenging.
[23]
Economic Environment:
Economic environment of a country is affected by the economic system, planning process,
economic structure, business fluctuations, and trends in macroeconomic variables, economic policies
and international economic environment. These various constituents of economic environment are
detailed as follows:
a. Economic System:
It is a set of institutions, principles and mechanisms created by a society to facilitate economic
units to address their basic economic problems of allocation of scarce resources and perform
their basic economic activities. Every organised society follows some or the other economic
system.
On the basis of ownership of resources, economic systems are classified into capitalism,
socialism and mixed economies. Whereas on the basis of market mechanism, the systems are
classified as market economies, planned economies and mixed economies.
b. Planning Process:
Planning is needed for an efficient allocation of resources, which are limited in supply, among
alternative uses. The planning process is an integral part of communist and socialist states.
However, retaining their basic free market structure, even capitalist economies use planning to
some extent. At present, all countries have mixed economic systems and follow planning, to a
smaller or greater extent, to stimulate the level of investment, encourage technological
innovations, use the resources as per national priorities and evolving economic situation, and
reconcile the process of economic growth with the overall socioeconomic development of the
country.
c. Economic Structure:
Economic System defines the institutional framework, whereas economic structure defines the
physical framework under which an economy and business units operate. The economic structure
is determined by the factors such as total population size, per capita income, demographic profile,
factor endowment, technological advancement, and is reflected in the sectoral composition of
output and employment, fiscal, financial and trade structure, and population structure.
…………………..
[24]
CHAPTER - 8
CAPITAL BUDGETING
Capital Budgeting
Capital Budgeting or investment appraisal is the planning process used to determine whether
an organisation’s long- term investment such as new machinery, replacement machinery, new plants,
new products and research development projects, are worth the funding of cash through the firm’s
capitalisation structure (debt, equity or retained earnings). It is the process of allocating resources for
major capital or investment, expenditures. One of the primary goals of capital budgeting investments
is to increase the value of the firm to the shareholders.
Investment:
It is an activity of spending resources (money, labour and time) on creating assets that can
generate income over a long period of time or which enhances the returns on the existing assets.
Capital budgeting is essentially a process of conceiving, analysing, evaluating and selecting the most
profitable project for investment. Capital budget is of great significance due to two reasons:
1. Capital expenditure is generally irreversible
2. The very survival of the firm depends on how well planned is its capital expenditure.
The ranking approach is adopted generally when a firm has a large amount of funds to
invest in several projects at the same time. The projects are ranked in order of their preferability
on the basis of the chosen objective.
1. Data Collection:
An important aspect of capital budgeting is to collect relevant, reliable and adequate data on the
following aspects of investment.
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(iii) the expected returns from the projects,
(iv) period of maturity, fruition and the productive life of the projects,
(v) the market rate of interest and
(vi) availability of internal and external finances.
Collection of required data on these aspects is necessary to determine where to invest and
how much to invest.
These criteria are equally applicable to a variety of investment decisions regarding new
investments and those pertaining to replacement, scrapping and widening or deeping capital.
Incidentally, from analysis point of view, there is no structural difference between decision on new
investment and those on replacement.
Let us now briefly describe the three criteria mentioned above and look into their
applicability. We will discuss these criteria under the condition of certainty. As mentioned above,
investment decisions under the condition of risk and uncertainly will be discussed in the next chapter.
The pay-back period is also known as 'pay-out' and 'pay-off' period. The pay-back period
method is the simplest and one of the most widely used methods of project evaluation. The pay-back
period is defined as the time required to recover the total investment outlay from the gross earnings,
i.e., gross of capital wastage or depreciation. If a project is expected to generate a constant flow of
income over its life-time, the pay-back period may be calculated as given below.
For example, if a project costs Rs. 40,000 million and is expected to yield an annual income
of Rs. 8,000 million, then its pay-off period is computed as follows :
In case of projects which yield cash in varying amounts, the pay-back period may be obtained
through the cumulative total of annual returns until the total equals the investment outlay. The sum of
cash inflows gives the pay-back period. For example, suppose that the cost of a project is Rs. 10,000
million which yields cash flows over 5 years as given in Col. 3 of Table 1. The table provides
necessary information for the calculation of pay-back period.
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3rd -- 2,500 10,000
4th -- 1,500 11,500
5th -- 1,000 12,500
As the table shows, the cumulative total of annual cash flows breaks-even with the total
outlay of the project ( . 10,000 million) at the end of the 3rd year. Thus, the pay-back period of the
project is 3 years.
In case of projects with different investments yielding different annual returns, the project
evaluation procedure can be described as follows. After pay-back period of each project is calculated,
projects are ranked in increasing order of their pay-back period. Let us suppose, for example, that a
firm has to select one out of four riskless projects, viz., A, B, C and D. The total cost of each project
and their respective annual yields are given in columns (2) and (3), respectively in Table-2. The
calculation of their respective pay-back period given in column (4) of the table. Project B ranks 1st and
projects C, D and A rank 2nd,3rd and 4th, respectively. The firm will invest in this project in the same
order, if it adopts the pay-back period criterion for project evaluation.
In case projects A, B, C and D yield cash flows at different rates in the subsequent years, the
cumulative total method can be adopted to calculate their pay-back periods as shown in Table-1 and
projects ranked accordingly. After projects are ranked, they are selected in order of their ranking
depending on the availability of funds.
All other things being the same, a project with a shorter pay-off period is preferred to those
with longer pay-off period. This method or ranking projects or project selection is considered to be
simple, realistic and safe. Its simplicity is obvious in the calculation of the pay-off period. It is
realistic in the sense that businessmen want their money back as quickly as possible and this method
serves their purpose. It is safe since it avoids incalculable risk in the long run.
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