Capital budgeting ordinarily takes place within the context of an organization’s overall strategy, coupled with whatever information is available concerning new opportunities, increased competition, new or pending legislation that might affect the organization’s efforts, and other similar considerations. During the capital budgeting process, senior management makes a variety of decisions of a long-term nature concerning the company’s product lines, the programs it will undertake, the new fixed assets it will acquire, and the approximate resources it will devote to each.
The decision are long-term since they concern resources that will exist for several, perhaps many, years. A new piece of equipment usually will last for three to five years, sometimes longer. A new or renovated facility may last ten to twenty years. Thus, the capital budgeting process frequently looks ahead by as much as 5 or 10 years. In some large organizations there is a lengthy program document that describes each proposal in detail, estimates the resources needed to accomplish it, and calculates the expected returns.
Although a decision to purchase a new fixed asset usually is assessed in terms of its long-term impact on financial status, it also has some short-term consequences. In particular, it will affect cash management via either the use of cash to purchase it or an increase in equity or debt to finance its acquisition. In this latter instance, assuming the debt is long-term, the short-term impact on cash is mitigated, resulting in a series of annual debt service outlays (principal and interest payments) rather than the large initial cash outlay that otherwise would be necessary.
CAPITAL INVESTMENT ANALYSES
A typical capital investment proposal involves an outlay of money at the present time (the investment) so as to realize a stream of cash inflows over some future period of time. For example, the acquisition of a new fixed asset —generally a piece of equipment or machinery, but occasionally a new or renovated facility of some sort—will almost always result in some future cash inflows. These inflows generally come about as a result of the asset’s ability to decrease operating expenses or increase revenues by an amount that exceeds the associated increase in expenses. The period during which these effects are felt is known as the economic life of the asset.
Three basic techniques can be used to determine whether the cash flows are sufficient to justify the initial outlay of funds: the payback period, net present value, and internal rate of return.
Technique #1. Payback Period
The payback period is the easiest technique. It consists of dividing the net investment amount by the estimated annual cash inflows attributable to the investment. The net investment amount is the purchase price of the new asset, plus installation costs, plus disposal costs of the asset being replaced, minus any revenue received from its sale. Annual cash flows are the reduced expenses or increased contribution attributable to the new asset. The quotient of the two is the number of years of cash inflows necessary to recover the investment.
Example: Nido Escondido Bank is considering the purchase of a $100,000 piece of equipment for its check processing activities. The new equipment will replace an existing piece of equipment, which the vendor has offered to repurchase for $20,000. It will also result in labor savings of approximately $40,000 a year. Thus, the net investment amount is $80,000 ($100,000 - $20,000 for the old equipment). The labor savings of $40,000 a year constitute the cash inflows attributable to the investment. The resulting payback period is two years ($80,000 ÷ $40,000).
The main advantage of the payback period is its simplicity, and it frequently is used to gain a rough sense of the feasibility of an investment opportunity. Its two main disadvantages are that it excludes the time value of money and does not permit comparisons among competing projects unless all have the same economic lives.
These disadvantages are related, and rest on the idea that a dollar saved a year from today is worth less than a dollar saved today, a dollar saved two years from today is worth even less, and so on. If the payback period is relatively short, as it was in the above example, this is not a particularly serious limitation, but with longer time horizons, the payback period’s utility is quite limited.
Technique #2. Net Present Value (NPV)
The NPV technique avoids the time-related disadvantage of the payback period by incorporating the time value of money into the analysis. It does so, as its name implies, by calculating the value in today’s terms of the . . .