From the course: Finance Foundations

Capital budgeting overview

From the course: Finance Foundations

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Capital budgeting overview

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Capital budgeting is making long-term asset purchase decisions. Capital; that's the word we use to refer to the financing obtained by a company in order to buy these long-term assets. Budgeting; that is numerically planning what we can expect in terms of earning a return on this asset that we're going to buy. Making long-term asset purchases involves large amounts of money. So we're talking about a large initial outlay of cash. If we make a mistake with these large spending decisions, we could struggle to survive. Also, because a capital budgeting purchase locks a company into a long-term asset, there's a potential long-term impact on earnings. Long-term assets are with you for a long time. Mistakes will punish you year after year. Another reason capital budgeting is important is because long-term asset purchases are difficult to reverse. Let me give you an example of the capital budgeting decision process. Franklin Noodle Shop is considering the purchase of a new dumpling machine. The machine is going to cost $10,000. At the end of 10 years, we will be finished using the dumpling machine and we estimate that we can sell it in the used machine market for $1,000. This new dumpling machine is going to reduce our cash operating costs by $700 a year. In addition, this new machine will increase our production by 10,000 dumplings a year, and we make $0.10 on each dumpling we sell. So that's a $1,000 increase in cash profit each year. Finally, our risk-adjusted cost of capital, 16 percent. So here is the question, should Franklin Noodle Shop purchase the new dumpling machine? Let's walk through the cash flows associated with the capital budgeting analysis. The original cost is a cash outflow of $10,000. In 10 years, we expect to be able to sell the used machine, so that's a cash inflow of $1,000. We also expect our cash operating costs to go down by $700 a year. Over 10 years, that means we're going to have a total increase in our cash of $7,000 because of reduced cash operating costs. We are also going to increase our productive capacity. Our cash profits will go up by $1,000 a year for 10 years. I'll do the arithmetic for us. The machine will cost us $10,000, but we're going to receive $1,000 when we sell the used machine. We're going to save $700 cash a year for 10 years, and we're going to have increased cash profits of $1,000 each year for 10 years. When I add up the numbers, they look good. -10,000 + 1000 + 7000, that's $700 a year for 10 years, plus 10,000, that's $1,000 a year for 10 years. The dumpling machine will give net positive cash flow of $8,000 over the 10-year life of the machine. Are we finished? Have we forgotten anything here? Yeah. What else could we have done with that $10,000 initial investment? Remember that our risk-adjusted cost of capital is 16 percent. That can also be thought of as our opportunity rate of return. We could have earned 16 percent per year on other investments. We've forgotten to include consideration of the time value of money. We won't go through the detailed calculations here, but with an interest rate of 16 percent, the correct decision is to not buy the dumpling machine. In making long-term decisions, such as whether to buy this dumpling machine with a life of 10 years, the time value of money is a factor essential to consider.

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