Whether your enterprise will thrive or struggle often hinges on decisions surrounding large expenditures. An owner’s purchase of an asset – such as equipment that will be functional for many years – typically entails a substantial sum of money.
These types of long-term assets are referred to as “capital expenditures.” They are not recorded as expenses on the income statement. Rather, they appear as assets on the balance sheet. Determining whether the cost for a capital expenditure is worthwhile necessitates a capital budgeting analysis to assure efficient allocation of resources.
Does it make sense
Your capital budgeting process begins with a ranking of large purchases in order of priority. This is how you decide when projects will be undertaken and how much capital is needed to accomplish them. Although some capital expenditures are urgently required to maintain operations, discretionary purchases are generally ranked based on their profitability.
Several methods are available for evaluating profitability of capitalized purchases. The most common ones – those followed by sophisticated business managers – are “net present value” and “internal rate of return.” Both processes consider cash flow over the entire length of a project and discount future cash flow to reflect the time value of money.
These methodologies contrast with the simplified payback model, which measures the amount of time required for recouping an investment. This non-discounted approach unrealistically regards future dollars as having the same value as current dollars.
Failure to consider profitability over the long term is another drawback to the payback model. A fast payback ultimately might not generate much profit, while a slow payback could disguise a vastly profitable undertaking over the life of the investment.
Quantifying the benefit
Discounted cash flow models are frequently used to identify the current value of a major purchase. The net present value method estimates all the future cash inflows and outflows. For example, cash inflow is the revenue expected from investing in a new piece of equipment, and cash outflow is the cost to purchase, maintain, and operate the equipment for generating that revenue.
The net cash flow over future periods is then discounted to a present value. Financial calculators and printed present value tables show the amount of value today that’s equivalent to future incoming cash. This is accomplished by assuming a discount rate reflecting the greater quantity of money we would accept in future to bring us the same happiness as would a lower sum today.
A positive net present value indicates the equipment will earn more than the discount rate. But even if the figure is negative, the equipment may still provide profitability (although likely not as much as avoiding the purchase and holding onto the money for the future). You can identify the rate of return for an investment by finding a discount rate that arrives at a net present value equal to zero. This internal rate of return determination is helpful for ranking expenditures in order of importance.
Confusing? Contact your accountant to help you understand how to value your capital expenditures.