The Integration of Capital Budgeting and Stock Valuation: Comment.

The article focuses on the attempt by E. Lerner and Willard T. Carleton to integrate the existing hypotheses of capital budgeting and stock valuation into one comprehensive theory. Lerner and Carleton developed a two equation model. The first is a valuation function and the second is an investment opportunities function. This model determines the optimal rate for two decision variables--the rate of return on assets and the earning retention rate which serves as a surrogate for the firm's investment budget. The optimal rates are defined as those which maximize the firm's market value. The basic error of the proposed model is that it is constructed to determine the optimal average rate of return rather than the marginal rate. Since the average rate of return does not reflect the specific form of the investment-opportunities function, it is not uniquely related to the marginal rate. Thus the average rate is ambiguous and is, therefore, an inappropriate variable on which to base capital investment decisions. Moreover, such a model is liable to lead to misinterpretations. However, the analysis of Lerner and Carleton's model proves that the implied marginal rate is lower than the cost of capital.