Monday, November 15, 2010

Capital Budgeting Part 1: Making Long-term Investment Decisions for Your Business


Capital budgeting is the decision-making process with respect to investments in long-term assets--machinery and equipment, vehicles, and real property--with the purpose of enhancing the value of a business. Some examples of capital budgeting decisions include:
  • The development and introduction of a new product to the market
  • Replacing an old piece of equipment with a newer model
  • Expanding production capacity
These decisions are "long term" since they cannot be "unmade" without incurring significant losses. And since these investments usually entail a huge amount of capital, it pays to know the best way of making such decisions.

The central idea in capital budgeting is to weigh the costs associated with the purchase against the expected benefits. Apart from the actual cost of the asset in question, like, say, an expensive deep fryer for your fried chicken business, other "costs" of the investment include transportation and installation (if they're not yet included in the sticker price of the machine) and investments in materials or inventory needed to make use of the asset (an increase in your inventory of dressed chicken). The benefits of the investment come from the additional cash flows you expect the asset to deliver in the future (maybe you're considering buying the new fryer because it can cook more chicken faster, which you estimate can boost your sales and cash flows significantly). In performing cost-benefit analysis, if the benefits of the asset in question outweigh the costs, then buying it would make economic sense; if it’s the other way around, if costs outweigh the benefits, then you would be better off spending your money on other value-boosting investments.

Unfortunately, of you really want to make the best decision for your business, you will have to complicate things a bit. In a previous post, we talked about time value of money: the idea that receiving money earlier is better, and vice versa. This notion complicates the cost benefit approach we discussed above; since cash received earlier is more valuable that that received at a later date, we can't just add all the future monetary benefits of an investment because they usually occur at different times. Which means, if you expect your new fryer to provide additional cash flows of 1 million pesos per year in the next five years, the benefit of the investment is not 1 million x 5 years = 5 million pesos because, with time value of money, the first million you'll receive is more valuable than the one you'll receive in five years. 

To better understand this concept, let's take a look at a specific example. Say, you're the owner of Cheeky Chicken, and you operate a small chain of fried chicken restaurants in the country. You're thinking of adding new capacity to your restaurants, and you're interested in buying a new deep fryer--the latest model--for 4 million pesos. Based on you rough estimates, the new fryer can bring in additional cash flows of 1 million pesos a year in the next five years, after which the machine will be fully depreciated and useless.

Without time value of money, the decision to buy the machine or not seems very uncomplicated: comparing the machine cost of 4 million pesos to the total benefit worth 5 million pesos clearly shouts buy. But what if you know you that can also invest your 4 million pesos in a fund that pays 5% per year? Now the decision to buy the machine or not is not so simple anymore, since now you have an alternative use for your capital that may provide better benefits. So how can we use this new information to make the right decision?

Those of you who still remember a bit of your high school math may be thinking along these lines: if we invest 4 million pesos at 5% per year, interest compounded annually (meaning interest also earns interest every year), that will give us 4 x (1.05)^5 or around 5.1 million pesos after five years, which is higher than the 5 million peso total benefit provided by the machine, which makes not buying the machine the right decision, right?

Well, almost, but not quite. While we have considered time value of money to evaluate the next best use for our capital (investing in the fund), we failed to use it with the benefits of the machine. Remember: with time value of money, earlier cash flows are worth more than those that come later, so the machine does not really provide a net benefit of 5 million pesos. So how exactly can we do this the right way? Well, you'll have to wait for Part 2 to find out. ;) 

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