One of the greatest challenges managers face is making capital investment decisions. The term capital investment refers broadly to large expenditures made to purchase plant assets, develop new product lines, or acquire subsidiary companies.
Such decisions commit financial resources for large periods of time and are difficult, if not impossible, to reverse once the funds are invested. Thus companies . stand to benefit from .good capital investments (or suffer from tones) for I many years.
The process of evaluating and prioritizing capital investment opportunities is called capital budget.
Capital budgeting relies heavily on estimates of future operating. results. These estimates often involve a considerable degree of uncertainty and should be evaluated accordingly. In addition, many non financial factors are taken into consideration.
Financial and “on financial Perhaps the most important financial consideration in capital budgeting is the expected effects future cash flows and future profitability. But in some cases, non financial considerations are the deciding factor.
We will now address” widely used methods of evaluating the financial aspects capital investment pop Oasis: payback period. return on average investment. and discounting future cash flows.
Evaluating Capital Investment Proposals: An Illustration
To illustrate the application of capital budgeting techniques, we will evaluate two investments being considered by the Maine Lob Stars (commonly referred to as the Stars), a minor league baseball team from Portland, Maine. The first involves the purchase of 10 vending machines for the team’s Portland stadium.
The second involves the purchase of a new bus to replace the one currently in use. The Stars’ stadium currently has no concession stand for preparing and selling food during games. Steve Wilson, the team’s owner, has received several bids for constructing a concession stand under the stadium bleachers.
The low bid of $150,000- includes a I,OOO-square-foot cement block building, equipped with cash registers, deep fryers, a grill, soda machines, and a walk-in freezer and cooler. Unfortunately, the most that the struggling organization is willing to invest for this purpose is $75,000. I Wilson recently received an alternative .proposal from Vindicator International. Vindicator sells vending machines that dispense hot and cold sandwiches and drinks.The company has feed to sell 10 vending machines to the Stars for ~75,OOO($7,500 each). While the machines are in use,
Vindicator is responsible for keeping them stocked with sandwiches and drinks. At the end ‘of a five year estimated life, Vindicator will repurchase the machines for $5,000 ($500 each). Vendor will also provide the.
Stars with an insurance and maintenance contract costing $3,000 per year. Estimates provided by Vindicator indicate that the 10 machines will take in $1,875 per ball game. The Stars pray 45 home games each season. Thus, the machines have the potentiality to general annual revenue of $84,375 ($1,875 per Greg Seiner/Gamma Liaison game X 45 games). Of this amount, Vindicator is to receive $50,625, representing the cost of goods sold (60% of sales). The Stars are required to reimburse Vindicator only for those items that sell, The machines are expected to increase the Stars’ net income by $10,000 per year, computed as follows:
Most capital budgeting techniques involve analysis of the annual net cash flows pertaining to an investment. Annual net cash flows refer to the excess of cash receipts over cash disbursements in a given year. We may assume in our example that all of the vending machine revenue is received in cash, and that all expenses (other than depreciation) are immediately paid in cash. In other words, the only difference between net income and’ net cash flows relates to-depreciation expense.
In our example, the vending machines are expected to increase both net income and net cash flows. But the real question is whether these increases are adequate to justify the required investment. We will attempt to answer this question using three different capital budgeting techniques.
The payback period is the length of time necessary to recover the entire cost of an investment from the resulting annual net cash flows. In our example, the payback period is computed as follows:
In selecting among alternative investment opportunities, a short payback period is considered desirable because the more quickly an investment’s cost is recovered, the sooner the funds may be put to other use.
A short payback period also reduces the risk that changes in economic conditions will prevent full recovery of an investment. However, the payback period should never be the only factor considered in a major capital budgeting decision because it ignores two important issues.
First, it ignores the total profitability ,and cash flows anticipated over the entire life of an investment (in this case, five years). Second, it ignores the timing of the future cash flows. We will address this issue in greater depth later in the
Return on Average Inventiveness
The return on average investment (ROI) is the average annual net income from an investment expressed as a percentage of the average amount invested. The Stars will initially have to invest $75,000 to purchase 10 new vending machines. However, each year depreciation expense will reduce the carrying value of these machines by a total of $14,000. Because the annual net cash flow is expected to exceed net income by this amount, we may view depreciation expense as providing for the recovery of the-amount
originally invested. Thus the amount that the Stars will have invested in the equipment at any given time is represented by the carrying value of the vending machines (their cost less accumulated depreciation).
When straight-line depreciation is used, the carrying value of an asset decreases uniformly over the asset’s life. Thus the average carrying
value over the life of an asset is. equal to the amount halfway between its original cost and its salvage value. If the salvage value is zero, the average carrying value (or average investment) is simply one-half of the asset’s original cost. Mathematically, the average amount invested over the life of an asset may be determined as follows:
Thus. over the life of the 10 new vending machines, the Stars will have an average investment of ($75,000 + $5,0(0) + 2, or $40,000. We.may compute the expected return on average investment as follows:
In deciding whether 25% is a satisfactory rate of return, Wilson should consider such factors as the reliability of Vindicator’s forecasts of income and cash flows, the return available from other investment opportunities, and the Stars cost of capital. J In comparing alternative investment opportunities, managers prefer the one with the lowest risk, the highest rate of return, and the shortest payback period.The concept ‘of return on investment shares a common weakness with the payback method. It fails to consider that the present value of an investment depends on the timing of its future cash flows. Cash flows received late in the life of an investment, for example, are of less value to an investor today than cash flows of equal amount received , early in the life of an investment. The return on investment computation simply ignores
the.question of whether cash receipts will occur early or late in the life of an investment. It also fails to consider whether the purchase price of the investment must be paid in advance or in installments stretching over a period of years. Discounting.future cash flows is a technique that does take into account cash fl.ow timing issues.
At Fields EverReady Architects & Engineers, the decision to provide their 55 employees with the ability to access.the Internet could be made with the payback criterion. The decision to hook up to the Internet’Was easy to because the yearly expected savings from reducing. forms of senior cost communicator”::”such as faxes, phone calls, messenger services, and ‘overnights higher than the Initial ,hook-up cods: Thus payback was an ad equate criterion because the time value of money was not a relevant Issue.