- Let's walk through an actual example
of a capital budgeting decision.
This is a real example that my wife, Ramona,
and I went through when we moved to Hong Kong.
Should we buy a car?
The cost of the car we were considering was
40,000 Hong Kong dollars.
Eight Hong Kong dollars is roughly equivalent
to one US dollar,
so that's about 5000 US dollars.
So we're not talking about a great car,
just a weekend car so we could save on subway
and bus fares for my wife and I and our children.
We figured that our annual savings would be
about 10,000 Hong Kong dollars.
We estimated the useful life
of the car to be about five years,
and for our family cost of capital, we use 10%.
So the capital budgeting decision is this.
Should the Stice family by this car?
Well, the first thing we did is compute the payback period.
If we spend 40,000 Hong Kong dollars to buy this car,
and we'll save $10,000 per year,
we will recover our investment cost in four years.
This is called the payback period.
All right, now let's do some present value calculations
to evaluate the Hong Kong car.
The car cost 40,000 Hong Kong dollars right now.
The savings will be $10,000 each year
for the next five years.
If the interest rate is 10%,
the present value of saving $10,000 each year
for five years is $37,908.
This number can be computed using a business calculator
or an Excel spreadsheet.
Well, computationally,
this is a pretty easy decision to make.
The cost of the car is $40,000.
If we buy the car,
we're going to receive savings
that have a value now of $37,908.
In other words, we're paying $40,000 to save $37,908.
Add these two numbers together, and you get minus $2092.
The label for this number is the net present value,
or NPV of the car.
The NPV of the car is minus $2092.
The instant that we decide to buy the car,
we lose $2092 in present value terms.
So should we buy the car?
The car has a negative net present value.
The worst thing you can say about something
in a finance context is
that it is a negative net present value project.
For example,
if you come up to me and you want to compliment me,
you should say this.
Oh, I was talking with your son the other day,
and he seems like a positive net present value project.
That's the nicest thing you can say to me.
The numbers say we should not buy the car,
but the numbers are just the start of the analysis.
Now we have to use our judgment.
We consider the numbers along
with the other nonfinancial benefits.
In this case, because of the numbers,
my wife, Ramona, and I decided not to buy the car,
and I think, as I think about it all these years later,
that we made a mistake.
We didn't properly weigh the nonfinancial benefits
in terms of transportation flexibility
to visit the many beautiful places out
in the mountains and beaches of Hong Kong.
We made the decision based on the numbers
when we probably should have used a little bit more judgment
and have considered the nonfinancial benefits
of having a car.
So remember, when making a capital budgeting decision
or any other decision, for that matter,
the numbers are just the start
of the decision-making process.
Once you've done the numbers,
then consider the other nonfinancial factors.