Demand and Supply of Capital for Investments

Demand for Capital

The demand schedule for capital refers to the arrangement of the various proposed projects in a descending order according to their estimated rates of return together with required amounts of capital needed by the respective projects.

Before analyzing the investments, the management must understand the nature of opportunities. Some investments are complimentary i.e. making one investment implies that another investment will be necessary. Some investments are mutually exclusive i.e. acceptance of one, implies rejection of others and some investments are independent. It is therefore necessary to identify the various opportunities of investments. Alternative investments can be ranked according to their relative profitability. It is also important to distinguish between cost reducing investment and revenue increasing investment.

According to W.W. Haynes “any investment decision is profitable if it adds more to revenue than to cost or if it reduces cost more than the revenue.”

An important element in the analysis of demand for capital is the productivity of proposed capital outlay. The yield must be calculated in terms of individual projects. It is the expected productivity of marginal unit of capital i.e. the key factor in the appraisal of allocating capital funds and not the profitability of the old and sunk investment based on the estimates of the historical costs. The past is useful only as a guide to the future i.e. the future profit which is more relevant and influences demand for capital; besides the capital yield should be calculated over the whole lifetime of the asset. Undoubtedly all the future ventures of capital investment involve risks.

Supply of Capital

There are fundamentally two sources of supply of capital:

  1. The internal sources of supply of capital are depreciation charges, and retained earnings. The capital expenditure of many firms is confined purely to the amount that can be secured internally. Therefore amount that can be expected from accumulated depreciation and from retained earnings comprises the most significant part of capital budgeting. The retained earnings as a source of supply of capital makes the plough back policy an integral part of capital budgeting.
  2. The external sources of capital are issue of shares and debentures and inter- firm borrowings. The external sources which depend on issue of shares, debentures and inter firm borrowings are very volatile and depend upon the overall atmosphere in the capital market, the company’s reputation, its financial backing and the integrity of its management. Whenever the firm decides to acquire external source of finance its project, it has to think many a times about the cost of capital.

Cost of Capital

The cost of capital is the rate which must be paid to obtain funds for operating the enterprise. As the supply of capital comes from several sources, each source has to be analyzed carefully because every source has a different cost component.

There are innumerable difficulties that arise while measuring the cost of capital and hence the determination of company’s cost of capital is subject to various margins of error. The computed values can be at the most regarded as fair approximations of the cost. The cost approximation includes the computation of the cost of debt capital, as well as cost of preference share capital, the cost of equity capital, the cost of retained earnings, the cost of depreciation funds etc. The capital costs are determined by a number of forces that exert their influence on capital markets. The Government itself is the single most important determinant of the interest rate structure through resorting to various policy measures by exercising control over reserve requirements, rediscounting facilities selective controls and open market operations. The Government influences the cost of capital. Similarly the investor’s psychology, their confidence and business outlook also affect the yields on security issues. Estimating the cost of capital requires the knowledge of market value of securities and cost of floatation.

To conclude, the cost of capital is a complex subject although determining the firm’s cost of capital is an essential part of capital budgeting process. Firms raise funds in many forms including long-term and short-terms debts, stock, retained earnings and lease financing. Each source of funds has a cost and these costs are the basic inputs in the cost of capital determination.