Capital budgeting and plant capacity

Abstract

In this paper a model which explicitly recognizes the relationships between the plant capacity, the lead time for building the plant, and the discount rate used in evaluating the project, is developed. It is shown that the introduction of a discount rate which is a function of capacity, substantially alters the results obtained in a previous study where the discount rate is assumed to be constant. In particular, since the net benefits of an additional unit of capacity is discounted using a higher rate, the NPV is suppressed. An extensive sensitivity analyses on the nonmonetary and monetary parameters and their effect of the optimal plant size vs optimal NPV is provided.