Much of the discussion has focused on decisions relating to near-term operations and activities. But, managers must also ponder occasional big-ticket expenditures that will impact many years to come.
Such capital expenditure decisions relate to construction of new facilities, large outlays for vehicles and machinery, embarking upon new product research and development, and similar items where the upfront cost is huge and the payback period will span years to come.
Although the tendency is to focus on the financial dimensions, such decisions are made even more complex because they usually involve a number of nonfinancial components as well. Thus, the final decision may involve consideration of architectural, engineering, marketing, regulatory, and numerous other variables.
These types of decisions involve considerable risk because they usually involve large amounts of money and extended durations of time. In addition, capital expenditure decisions (also called capital budgeting) are usually accompanied by a number of alternatives from which to choose. Sometimes, an option that is best in the long term may be the least desirable in the near term, and vice versa.
For instance, a student may currently invest time and money in an education; probably the student could make more money in the near term by working more hours in a paying job and devoting less time to study. However, the long term is frequently better served by investing in education. The same challenge often faces managers. For example, should a new computer information system be installed? In the near term, the business might appear more profitable by not buying a new system, but the long run may be better served by making the investment.
Stewardship
Capital expenditure planning requires managers to effectively evaluate and rank alternatives. This process must be matched/tempered by reasonable assessment of resource limitations and willingness to assume risk. In addition, managers must understand the goals of business owners: What is to be optimized, short-run or long-run performance goals? How much risk is to be undertaken in pursuit of an opportunity?
Managers naturally feel pressure to deliver in the near term, for fear of not keeping their jobs in the long term. Be on guard, as this behavioral issue can potentially foster an environment where the best long-run decisions are not always selected.
Logic Of Capital Decisions
Fortunately, a number of analytical tools are available to bring logical and rationale decision-making processes to bear on capital expenditure decisions. The remainder of this chapter will focus on these tools. A good manager is well advised to understand and utilize these tools. They can be most helpful in evaluating capital expenditure decisions. In addition, managers can use these tools to clearly convey justification for making certain decisions, even if they appear to be illogical in the near-term.
The capital budgeting tools covered in the remainder of this chapter are net present value, accounting rate of return, internal rate of return, and payback method. These tools require foundational knowledge in compound interest and present value techniques, as provided in the next section.
| Did you learn? |
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| What is a capital expenditure? |
| Describe the capital budgeting process. |