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 budgetingcapital 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 availablelarge 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?
