First, a firms capital budgeting decisions define its strategic direction, because moves into new products, services, or markets must be preceded by capital expenditures.
And, third, poor capital budgeting can have serious financial consequences. If the firm invests too much, it will incur unnecessarily high depreciation and other expenses.
On the other hand, if it does not invest enough, its equipment and/or software may not be sufficiently modern to enable it to produce competitively. Also, if it has inadequate capacity, it may lose market share to rival firms, and regaining lost customers requires heavy selling expenses, price reductions, or product improvements, all of which are costly.
A recent news headline serves to illustrate the inevitable downstream cost to one company for not having invested enough capital in its servers and network in a timely fashion: "Penny Wise, Pound Foolish".
This April, on the morning following the deadline for filing U.S. federal income tax returns, the Internal Revenue Service said it would not penalize TurboTax and ProSeries users whose 11th-hour electronic returns were delayed by Intuit's over-loaded servers.
A record number of returns from both individual taxpayers and accountants started causing delays in customers receiving online confirmation that their tax returns were submitted successfully.
As the midnight filing deadline approached, the problem got worse. During times of peak demand, Intuit was processing 50-to-60 returns per second.
Fortunately for the affected taxpayers, the IRS announced that filers who encountered delays with Intuit's servers will not be penalized if their returns rolled in late. The reprieve also extends to people who tried to file in the hours before the deadline but could not.
Had Intuit invested more capital to upgrade it servers and network, it would not now be facing, post priori, operating expenses needed to restore customer confidence in its services.
Capital vis-à-vis Operational Budgets
Capital spending on, for example, new hardware or application server software, and operating spending on, say, salaries and other public relations expenses, are different and yet, as suggested in the previous sentence, related.
Often the time period for spending and generally the means of financing (for example, borrowing for capital spending vs. current revenues for operating spending) are different.
Though they are different types of budgets, the capital and operating budgets are interconnected in many ways, foremost by annual service of debt or other obligations that finance the capital plan.
Annual debt service is usually included in and paid from the operating budget. In addition, many capital assets, such as computer hardware or software, require annual operating expenses for operation and maintenance, among other items. In some cases, capital spending in a given year may be financed by using current revenues (pay-as-you-go financed).
Carefully developed capital projects can also save operating expenses, by creating more efficient ways to provide services, or by introducing energy-saving measures, for example. The impact of capital expenditures in total on the operating budget should be carefully considered before capital budgets are made.
In advance of committing to a given level of capital investment, the debt service needed to support borrowing (or the amount of cash earmarked for dividends) needs to be calculated as is the need for new revenues.
Thus, the capital budget is constrained by revenues available to pay for it. New or available revenues to pay debt service define debt affordability, which drives the size of the new financing program.
The concept of debt affordability, in particular, takes into account the long-term effects of debt repayment on operating budgets. And, debt service obligations, without new funding, will compete with the undertaking of new projects.
A debt affordability policy is needed to maintain a firms good credit rating and, thereby hold down its cost of capital (discussed below).
Analyzing capital expenditure proposals is not a costless operation. For certain types of projects, a relatively detailed analysis may be warranted. For others, simpler procedures should be used.