Capital budgeting models based on constrained profit maximizing and non-profit maximizing behavior
DeJong, Siert Edward
Levy, Ferdinand K.
Doctor of Philosophy
Although economic literature traditionally assumes maximization of total profits to be the only goal of the firm, recently some alternative entrepreneurial motivations have received much attention. Nevertheless, in the theory of investment practically all the existing models, positive and normative, are based on profit maximization. Attempting to fill this gap this dissertation develops a series of capital budgeting models based on a few of the best known of these alternative objectives. Since the purpose was not to construct new goals or to argue for the plausibility of some, the goals and motives of the firm. were taken as given. Four different goals were used. Two are constrained profit maximizing, one is revenue maximization, and the fourth is the maximization of the manager's own utility. The capital budgeting problem, broadly interpreted, requires three interrelated decisions: first, the determination of the total volume of investment the firm will undertake, second, the optimal financing of the proposed investment outlay and third, the selection of the optimal combination of investment projects. These sub-problems are successively analyzed (respectively in Chapters III, IV.1 and IV.2), and a model to solve each for the four different objectives is constructed in each chapter. Optimality conditions, optimality rules and micro investment equations corresponding to the various goals are derived. The thesis actually begins in Chapter II with a review of well known capital budgeting models which are similar in that all conclude investment should (will) be carried on by the firm until the marginal rate of return equals the marginal cost of capital. But since all define the cost of capital differently the models in fact lead to quite different investment behavior. It is shown that the differences in opinion about the "correct" definition of the cost of capital are due to different interpretation of the profit maximization hypothesis. This chapter serves a threefold purpose. First, it serves as an introduction by presenting some traditional capital budgeting models against which the models of Chapter III and IV can be compared. Second, it helps to clear a confusing discussion that has been going on for years in financial literature by showing that each model is internally consistent and that differences in outcome are caused by differences in initial assumptions as to what constitutes the goal of the firm. Third, by showing haw even minor variations on the profit maximization theme can cause quite different investment behavior, it demonstrates the need for models integrating more radically different objectives with the theory of investment. The model used in Chapter III is a modified and generalized version of the so-called "wealth-model". The unrealistic and special behavioral assumption of that model is replaced by the more basic "balance-equality constraint" and the resulting model is made to accept the various non-profit maximizing goals. The problem in Chapter IV.1 is structured so that it can be solved by existing programming methods. Although the mathematical technique is known, the application to the financing problem in this form is quite new. In Chapter IV.2 existing programming methods for determining the optimal project mix under profit maximization are proven to be applicable to most of the other objectives as well.