Capital Budgeting^95
The second side of a capital-budgeting decision is to determine the required return
from a project. We may calculate the likely return to be 12 percent but the question
is whether this is good enough for the proposal to be accepted. In order to determine
whether the return is adequate, the aualyst must evaluate the degree of risk in the
project and then must calculate the, required return for the given risk level. Two
techniques may be used to perform this analysis. The weighted-average cost of
capital is used when the new proposal is assumed to have the same degree of risk
as the firmís existing activities. The capital asset pricing model is used if the risk in
the project is viewed as different from the firmís current risk level.
Capital budgeting is important for the future well-being of the firm; it is also a complex,
conceptually difficult topic. A, we shall see later in this chapter, the optimum capital
budget-the level of investment that maximizes the present value of the firm is
simultaneously determined by the interaction of supply and demand forces under
conditions of uncertainty. Supply forces refer to the supply of capital, the firm or its
cost of capital schedule. Demand forces relate to the investmenl opportunities open
to the firm, as measured by the stream of revenues that will result from an investment
decision Uncertainty enters the decision because it is impossible to know exactly
either the cost of capital or the stream of revenues that will be derived from a project.
Significane of Capital Budgeting
A number of factors cornbine to make capital budgeting perhaps the most important
decision with which financial management is involved. Further, a departments Of a
firm-production, marketing, and so on, are vitally affected by the capital budgeting
decisions, so all executives, no matter what their primary responsibility, must be aware
of how capital budgeting decisions are made, These points are discussed in this section.
Long Term Effects
First and foremost, the fact that the results continue over an extended period means
that the decision maker loses some of his flexibility. He must make a commitment into
the future. For example, the purchase of an asset with an economic life of ten years
requires a long period of waiting before the final results of the action can be known.
The decision maker must commit funds for this period, and, thus, he becomes a hostage
of future events.
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