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3. Capital Expenditure Decisions

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 we will focus on the financial dimensions, it goes without saying that such decisions are made more complex because they usually involve a number of nonfinancial components as well. Thus, the final decision may involve consideration of architectural, engineering, marketing, 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 near-term may be the least desirable in the long-term, and vice versa. For instance, you are currently investing time and money in your education; probably you could make more money in the near-term by working more hours in a paying job and devoting less time to study - but you know the long-term is better served by investing in your 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.

3.1. Management 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!

3.2. Logic Justification of Capital Decisions

Fortunately, a number of very helpful analytical tools are available to bring logical and rational 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.

4. Compound Interest and Present Value

You have heard the expression that "time is money." In capital budgeting this concept is measured and brought to bear on the decision process. The fundamental idea is that a dollar received today is worth more than a dollar to be received in the future. This result occurs because a dollar in hand can be invested to generate additional returns; such would not be the case with a dollar received in the future.

In the context of capital budgeting, assume two alternative investments have the same upfront cost. Investment Alpha returns $100 per year for each of the next five years. Investment Beta returns $50 per year for each of the next 10 years. Based solely on this information, you should conclude that Alpha is preferred to Beta. Although the total cash returns are the same, the time value of money is better for Alpha than Beta. With Alpha, the money is returned sooner, allowing for enhanced reinvestment opportunities. Of course, very few capital expenditure choices are as clear cut as Alpha and Beta. Therefore, accountants rely on precise mathematical techniques to quantify the time value of money.

 
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