96 Financial Management
has not spent enough on fixed assets, two serious problems may arise. First, the firmís
equipment may not be sufficiently modern to enable it to produce competitively. Second,
if it has inadequate capacity, it may lose a portion of its share of the market to rival
firms. To regain lost customers typically requires heavy selling expenses, price reduction,
product improvements, and so forth.
Timing the Availability of Capital Assets
Another problem is to phase properly the availability of capital assets in order to have
them. come ìon streamî at the correct time. For example, the executive vice-president
of a decorative tile company gave the authors an illustration of the importance of
capital budgeting. His firm tried to operate near capacity most of the time. For about
four years there had been intermittent spurts in the demand for its product; when these
spurts occurred, the firm had to turn away orders. After a sharp increase in demand,
the firm would add capacity by renting an additional building, then purchasing and
installing the appropriate equipment. It would take six to eight months to have the
additional capacity ready. At this point the company frequently found that there was
no demand for its increased output-other firms had already expanded their operations
and had taken an increased share of the market, with the result that demand for this
firm had leveled off. If the firm had properly forecast demand and had planned its
increase in capacity six months or one year in advance, it would have been able to
maintain its market-indeed, to obtain a larger share of the market.
Quality of Capital Assets
Good capital budgeting will also improve the timing of asset acquisitions and the quality
of assets purchased. This situation follows from the nature of capital goods and their
producers. Firms do not order capital goods until they see that sales are beginning to
press on capacity. Such occasions occur simultaneously for many firms. When the
heavy orders come in, the producers of capital goods go from a situation of idle
capacity to one where they cannot meet all the orders that have been placed. Consequently,
large backlogs accumulate. Since the production of capital goods involves a relatively
long work-in-process period, a year or more of waiting may be involved before the
additional capital goods are available. This factor has obvious implications for purchasing
agents and plant managers.
Asset expansion is fundamentally related to expected future sales. A decision to buy
or to construct a fixed asset that is expected to last five years involves an implicit five-
year sales forecast. Indeed, the economic life of a purchased asset represents an
implicit forecast for the duration of the economic life of the asset. Hence, failure to
forecast accurately will result in over investment or under investmnent in fixed assets.
An erroneous forecast of asset requirements can result in serious consequences. If the
firm has invested too much in assets, it will incur unnecessarily heavy expenses. If it
has not spent enough on fixed assets, two serious problems may arise. First, the firmís