- [Instructor] 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 assets 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 dollars,
and at the end of 10 years, we'll be finished using
the dumpling machine, and we estimate that we can sell
it in the used machine market for 1,000 dollars.
This new dumpling machine is going to reduce
our cash operating costs by 700 dollars a year.
In addition, this new machine will increase
our production by 10,000 dumplings a year,
and we make 10 cents on each dumpling we sell.
So that's a 1,000 dollar increase in cash profit each year.
Finally, our risk adjusted cost of capital, 16%.
So here's the question.
Should Franklin Noodle Shop purchase
the new dumpling machine?
Let's walk through the cash flow associated
with the capital budgeting analysis.
The original cost is a cash outflow of 10,000 dollars.
In 10 years, we expect to be able to sell
the used machine, so that's a cash inflow of 1,000 dollars.
We also expect our cash operating cost
to go down by 700 dollars a year.
Over 10 years, that means we're going to have
a total increase in our cash of 7,000 dollars
because of reduced cash operating cost.
We are also going to increase our productive capacity.
Our cash profits will go up by
1,000 dollars a year for 10 years.
I'll do the arithmetic for us.
The machine will cost us 10,000 dollars.
But we're going to receive 1,000 dollars when we sell
the used machine, we're going to save 700 dollars cash
a year for 10 years, and we're going to have increased
cash profits of 1,000 dollars each year for 10 years.
When I add up the numbers they look good.
Minus 10,000, plus 1,000, plus 7,000, that's 700 dollars
a year for 10 years, plus 10,000, that's 1,000 dollars
a year for 10 years, the dumpling machine
well give net positive cash flow of 8,000 dollars
over the 10 year life of the machine.
Now are we finished?
Have we forgotten anything here?
Yeah, what else could we have done
with that 10,000 dollar initial investment?
Remember that our risk adjusted cost of capital is 16%.
That can also be thought of as
our opportunity rate of return.
We could have earned 16% per year on other investments.
We forgot 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%,
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 factor essential to consider.