Importance of capital budgeting

А number of factors combine to make capital budgeting decisions perhaps. he most important ones financial managers must make. First, since the results of capital budgeting decisions continue for many years, the decision maker loses some of his or her flexibility. For example, the purchase of an asset with an economic life of 10 years "locks in" the firm for a 10-year period. Further, because asset expansion is fundamentally related to expected future sales, a decision to buy a fixed asset that is expected to last 10 years involves an implicit 10-year sales forecast.

An error in the forecast of asset requirements can have serious consequences. If the firm invests too much in assets, it will incur unnecessarily heavy expenses. If it does not spend enough on fixed assets, two problems may arise. First, its equipment may not be efficient enough to enable it to produce competitively. Second, if it has inadequate capacity, it may lose a portion of its market share to rival firms, and regaining lost customers requires heavy selling expenses and price reductions, both of which are costly.

Timing is also important in capital budgeting—capital assets must be ready to come "on line" when they are needed. Edward Ford, executive vice president of Western Design, a decorative tile company, gave the author an illustration of the importance of capital budgeting. His firm tries to operate near capacity most of the time. During a four-year period, Western experienced intermittent spurts in the demand for its products, which forced it to turn away orders. After these sharp increases in demand, Western would add capacity by renting an additional building, then purchasing and installing the appropriate equipment. It would take six to eight months to get the additional capacity ready, but frequently by that time demand had dried up other firms had already expanded their operations and had taken an increased share of the market. If Western had properly forecasted demand and planned its capacity requirements a year or so in advance, it would have been able maintain or perhaps even increase its market share.

Effective capital budgeting can improve both the timing of asset acquisition and the quality of assests purchased. A firm which forecasts its needs for capital assets in advance will have an opportunity to purchase and install the assets before they are needed. Unfortunately, many firms do not order capital goods until they approach full capacity or are forced to replace worn-out equipment. If sales increase because of an increase in general market demand, all firms in the industry will tend to order capital goods at about the same time. This results in backlogs, long waiting times for machinery, a deterioration in the quality of the capital goods, and an increase in their prices. The firm which foresees its needs and purchases capital assets early can avoid these problems. Note, though, that if a firm forecasts an increase in demand and then expands to meet the anticipated demand, but sales then do not expand, it will be saddled with excess capacity and high costs. This can lead to losses or even bankruptcy. Thus, an accurate sales forecast is critical.

Finally, capital budgeting is also important because asset expansion typically involves substantial expenditures, and before a firm can spend a large amount of money, it must have the funds available—large amounts of money are not available automatically. Therefore, a firm contemplating a major capital expenditure program should arrange its financing several years in advance to be sure the funds required are available.

Self-Test Questions

Why are capital budgeting decisions so important to the success of a firm? Why is the sales forecast a key element in a capital budgeting decision?

Generating ideas for capital projects

The same general concepts that we developed for security analysis are involved in capital budgeting. However, whereas a set of stocks and bonds exists in the securities market, and investors select from this set, capital budgeting projects are created by the firm. For example, a sales representative may report that customers are asking for a particular product that the company does not now produce. The sales manager then discusses the idea with the marketing research group to determine the size of the market for the proposed product. If it appears likely that a significant market does exist, cost accountants and engineers will be asked to estimate production costs. If it appears that the product can be produced and sold at a sufficient profit, the project will be undertaken.

A firm's growth, and even its ability to remain competitive and to survive, depends upon a constant flow of ideas for new products, ways to make existing products better, and ways to produce output at a lower cost. Accordingly, a well-managed firm will go to great lengths to develop good capital budgeting proposals. For example, the executive vice president of one very successful corporation indicated that his company takes the following steps to generate projects:

Our R&D department is constantly searching for new products and also for ways to improve existing products. In addition, our executive committee, which consists of senior executives in marketing, production, and finance, identifies the products and markets in which our company will compete, and the committee sets long-run targets for each division. These targets, which are spelled out in the corporation's strategic business plan, provide a general guide to the operating executives who must meet them. These executives then seek new products, set expansion plans for existing products, and look for ways to reduce production and distribution costs. Since bonuses and promotions are based in large part on each unit's ability to meet or exceed its targets, these economic incentives encourage our operating executives to seek out profitable investment opportunities.

While our senior executives are judged and rewarded on the basis of how well their units perform, people further down the line are given bonuses for specific suggestions, including ideas that lead to profitable investments. Additionally, a percentage of our corporate profit is set aside for distribution to nonexecutive employees, and we have an Employees' Stock Ownership Plan (ESOP) to provide further incentives. Our objective is to encourage employees at all levels to keep on the lookout for good ideas, including those that lead to capital investments.

If a firm has capable and imaginative executives and employees, and if its incentive system is working properly, many ideas for capital investment will be advanced. Since some ideas will be good ones while others will not, procedures must be established for screening projects, our topic in the remainder of the chapter.

Self-Test Question

How does a firm get ideas for capital projects?

Oject classifications

Analyzing capital expenditure proposals is not a costless operation—benefits can be gained, but analysis does have a cost. For certain types of projects, a relatively detailed analysis may be warranted; for others, simpler procedures should be used. Accordingly, firms generally classify projects into the following categories, and they analyze projects in each category somewhat differently:

1. Replacement: maintenance of business. One category consists of expenditures necessary to replace worn-out or damaged equipment used in the production of profitable products. These replacement projects are necessary if the firm is to continue in business. The only issues here are (a) should we continue to produce these products or services, and (b) should we continue to use our existing production processes? The answers are usually "yes," so maintenance decisions are normally made without going through an elaborate decision process.

2. Replacement: cost reduction. This category includes expenditures to replace serviceable but obsolete equipment. The purpose here is to lower the costs of labor, materials, or other inputs such as electricity. These decisions are discretionary, and a more detailed analysis is generally required to support them.

3. Expansion of existing products or markets. Expenditures to increase output of existing products, or to expand outlets or distribution facilities in markets now being served, are included here. These decisions are more complex, because they require an explicit forecast of growth in demand. Mistakes are more likely, so a still more detailed analysis is required, and the final decision is made at a higher level within the firm.

4. Expansion into new products or markets. These are expenditures necessary to produce a new product or to expand into a geographic area not currently being served. These projects involve strategic decisions that could change the fundamental nature of the business, and they normally require the expenditure of large sums of money over long periods. Invariably, a very detailed analysis is required, and the final decision is generally made at the very top—by the board of directors as a part of the firm's strategic plan.

5. Safety and/or environmental projects. Expenditures necessary to comply with government orders, labor agreements, or insurance policy terms fall into this category. These expenditures are often called mandatory investments, or nonrevenue -producing projects. How they are handled depends on their size, with small ones being treated much like the Category 1 projects described above.

6. Other. This catch-all includes office buildings, parking lots, executive aircraft, and so on. How they are handled varies among companies.

In general, relatively simple calculations, and only a few supporting documents, are required for replacement decisions, especially maintenance-type investments in profitable plants. More detailed analysis is required for cost-reduction replacements, for expansion of existing product lines, and especially for investments in new products or areas. Also, within each category projects are broken down by their dollar costs: Larger investments require both more detailed analysis and approval at a higher level within the firm. Thus, although a plant manager may be authorized to approve maintenance expenditures up to $10,000 on the basis of a relatively unsophisticated analysis, the full board of directors may have to approve decisions which involve either amounts over $ 1 million or expansions into new products or markets. Statistical data are generally lacking for new product decisions, so here judgments, as opposed to detailed cost data, are especially important time basis will also mean that quantitative analyses will be used routinely to "test out" alternative courses of action. As a result, the next generation of financial managers will need stronger computer and quantitative skills than were required in the past.

Self-Test Question

How has financial management changed from the early 1900s to the 1990s?