98 Financial Management
amount of money, it must make the proper plans-large amounts of fund are not available
automatically. A firm contemplating, major capital expenditure program may need to
arrange its financing several years in advance to be sure of having the funds required
for the expansion.
Ability to Compete
Finally, it has been said with a great deal of truth that many firms fail, not because they
have too much capital equipment but because they have too little. While the conservative
approach of having a small amount of capital equipment may be appropriate at times,
such an approach may also be fatal if a firmís competitors install modern, automated
equipmen that permits them to produce a better product and sell it at a lower price.
The same thing also holds true for nations: If United States firms fail to modernize but
those of other nations do, then the u.s. will not be able to compete in world markets
Thus, an understanding of business investment behavior and of factors that motivate
firms to undertake investment programs is vital for congressional leaders and others
involved in governmental policy making.
Application of the Concept
At the applied level, the capital budgeting process is much more complex than what
it looks. Projects do not just appear, a continuing stream of good investment opportunities
results from hard thinking, careful planning, and, often, large outlays for research and
development Moreover, some very difficult measurement problems are involved: the
sales and costs associated with particular projects must be estimated, frequently many
years into the future, in the face of great uncertainty. Finally, some difficult conceptual
and empirical problems arise over the methods of calculating rates of return and the
cost of capital.
Businessmen are required to take action, however, even in the face of the kinds of
problems described; this requirement has led to the development of procedures that
assist in making optimal investment decisions.
Difficulties in Capital Budgeting
While capital expenditure decisions are extremely important, they also pose difficulties,
which stem from three principal sources:
lllll Measurement Problems Identifying and measuring the costs end benefits of a
capital expenditure proposal tends to be difficult. This is more so when a capital
expenditure has a bearing on some other activities of the firm (like cutting into
the sales of some existing product) or has some intangible consequences (like
improving the morale of workers).
lllll Uncertainty A capital expenditure decision involves costs and benefits that
extend far into future. It is impossible to predict exactly what will happen in
future. Hence, there is usually a great deal of uncertainty characterizing the
costs and benefits of a capital expenditure decision.