CAPITAL BUDGETING

We have learn how how investors value corporate securuities and how investor determine
required rates of return, and we have also seen how managers make working capital
decisions, including decision how to increase current assets. Now we turn to investment
decisions involving fixed assets, or capital budgeting. Here the term capital preference refers
to fixed assets used in production, while a budget is a plan which projected inflow and
outlows during some future period. Thus, the cpital budegeting is an outline of planned
expenditirues on fixed assets, and capitail budgeting is the whole project and deciding
wheter they should be included in the capital budget.

IMPORTANCE OF CAPITAL BUDGETING

A number of factors combine to make capital budgeting decisions perhaps the 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 tlexibility.

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. However, if it does not
spend enough on fixed assets, two problems may arise : (1.) Its equipment may not be
efficient enough to enable it to produce competitively. (2.) 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 costy. Timing is also
important in capital budgeting-capital assets must be ready to come "on line" when they are
needed.

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

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

GENERATING IDEAS FOR CAPITAL PROJECTS

The same general concepts that developed for securiry analysis are iavolvecd in capital
budgeting, However, whereas a set of stocks and bonds exists in the security market and
investors select from this set, capital budgeting projects are created by he firm.

A firm's growth, and event 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
product output at a lower cost. Accordingly, a well-managed firm will go to great lengths to
develop good capital budgeting proposals.

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. Because some capital
investment ideas will be good and others will not, procedures must be established for
evaluating the worth of such projects to the firm. Thats way our topic is the evaluation of the
worth (acceptability) of capital projects.

PROJECT CLASSIFICATIONS

Analyzing capital expenditure proposals is not costless operation—benefits can be gained,

but analysis does have a cost. Accordingly, firms generally classify projects into the
following categories:

1. Replacement: maintenance of business. One category consists of expenditures to

replace worn-out or damaged equipment used in the production of profitable
products. These replacement projects are necessary if the operation is to continue, so
the only issues here are (a) should we continue to produce these products or services,
and (b) should we continue to use our cxisting production processes? The answers
are usually yes," so maintenance decisions are normally made without going through
an claboratc 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. Expencitures 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 still more detailed
analysis is required, and the final decision is made at higher level within the firm.
4. Expausion 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 project involve strategic decision that could change the fundamental
nature of the business, and thei 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 eavironmental projects. Expenditures necessary to comply with
government orders, labor agreements, or insurance policy terms fall into this
category. These expenditures are often called mandatory investment, or nonreveneu-
producing project. How they are handled depends on their size, with small ones
being treated much like the category 1 project described above.
6. Other. This catch-all includes office buildings, parking lots, executive aircraft, and
so on. How they are handled varies among companies.