Why It Matters

Figure 11.1 Milling Manufacturing. Long-term project investment requires careful capital budgeting analysis. (credit: modification of “Parts for CNC Machine” by Andy Malmin/Flickr, CC BY 2.0)

Chapter Outline

11.1 Describe Capital Investment Decisions and How They Are Applied

11.2 Evaluate the Payback and Accounting Rate of Return in Capital Investment Decisions

11.3 Explain the Time Value of Money and Calculate Present and Future Values of Lump Sums and Annuities

11.4 Use Discounted Cash Flow Models to Make Capital Investment Decisions

11.5 Compare and Contrast Non-Time Value-Based Methods and Time Value-Based Methods in Capital Investment Decisions

Jerry Price owns Milling Manufacturing, a production facility geared toward entrepreneurial product development. Initially, Jerry purchased several milling machines, but after seven years, the machines have become obsolete due to technological advances. Jerry must purchase new machines to continue business growth, and there are several options available. How does he choose the best machines for his business? What factors must he consider before purchase?

Jerry must consider several important factors—both financial and non-financial—as he makes this decision. First, he needs to consider the commitment of his initial capital investment. He also needs to compare differences between options such as warranties, the production capacities of different machines, and maintenance and repair costs. Another factor is the useful life of the new equipment—in other words, both its physical and the technological life. He will also consider how long it will take to recoup the cost of the investment, the impact on cash flow, and how the passage of time affects the value of the asset to the organization—it’s monetary value that considered depreciation to determine what the asset is actually worth to the organization in terms of dollars (i.e., “what could we sell it for?”). Jerry will consider the value of the dollar invested today in purchasing the machine as opposed to the value of the dollar in the future that might be better spent on another project. This last factor is significant because the new equipment will probably provide part of his down payment on future replacement equipment. There are also nonfinancial factors to consider, such as changes to customer satisfaction and employee morale.

Jerry knows this equipment choice goes well beyond color or price preferences. The decision has a long-lasting influence on company direction and opportunity, and he needs to utilize capital budgeting analysis to help him make this decision.