Explanation+and+Examples

__** Concept of Capital Investment Decisions **__

- Capital investment definition: [|Money]  invested in a [|business venture]  with an [|expectation]  of [|income] , and recovered through [|earnings]  generated by the [|business]  over several years. It is generally understood to be used for [|capital expenditure]  rather than for [|day-to-day][|operations] <span style="color: #000000; font-family: 'Arial','sans-serif'; font-size: 20px;"> ( <span style="color: #000000; font-family: 'Arial','sans-serif'; font-size: 20px; text-decoration: none;">[|working capital] <span style="color: #000000; font-family: 'Arial','sans-serif'; font-size: 20px;">) or other <span style="color: #000000; font-family: 'Arial','sans-serif'; font-size: 20px; text-decoration: none;">[|expenses] <span style="color: #000000; font-family: 'Arial','sans-serif'; font-size: 20px;">. - <span style="color: #333333; font-family: 'Arial','sans-serif'; font-size: 20px;">Capital investment decision (or “Capital budgeting”) is the planning process used to determine a firm’s expenditures on assets whose cash flows are expected to extend beyond one year such as new machinery, equipment, etc. It is also the process of identifying, analyzing and selecting investment projects whose cash flows are expected to extend beyond one year such as research and development project. Capital expenditures can be very large and have a significant impact on the firm’s financial performance. Besides, the investments take time to mature and capital assets are long-term, therefore, if a mistake were done in the capital budgeting process, it will affect the firm for a long period of time. - <span style="font-family: 'Arial','sans-serif'; font-size: 20px;">Examples of capital investment decisions: a manufacturing firm invests into new plant, a medical firm invests into medical research… - <span style="font-family: 'Arial','sans-serif'; font-size: 20px;">Typical capital investment decisions include:
 * <span style="font-family: 'Arial','sans-serif'; font-size: 20px;">Cost reduction decisions. Should new equipment be purchased to reduce costs?
 * <span style="font-family: 'Arial','sans-serif'; font-size: 20px;">Expansion decisions. Should a new plan, warehouse, or other facility be acquired to increase capacity and sales?
 * <span style="font-family: 'Arial','sans-serif'; font-size: 20px;">Equipment selection decision. Which of several available machines should be the most cost effective to purchase?
 * <span style="font-family: 'Arial','sans-serif'; font-size: 20px;">Lease or buy decisions. Should new equipment be leased or purchased?
 * <span style="font-family: 'Arial','sans-serif'; font-size: 20px;">Equipment replacement decisions. Should old equipment be replaced now or later?

__** Concept of Opportunity Cost **__

<span style="font-family: 'Arial','sans-serif'; font-size: 20px;">Capital budgeting normally relates to evaluating opportunity cost of several plans. - <span style="font-family: 'Arial','sans-serif'; font-size: 20px;">Opportunity cost definition: A <span style="color: #000000; font-family: 'Arial','sans-serif'; font-size: 20px; text-decoration: none;">[|benefit] <span style="font-family: 'Arial','sans-serif'; font-size: 20px;">, <span style="color: #000000; font-family: 'Arial','sans-serif'; font-size: 20px; text-decoration: none;">[|profit] <span style="font-family: 'Arial','sans-serif'; font-size: 20px;">, or <span style="color: #000000; font-family: 'Arial','sans-serif'; font-size: 20px; text-decoration: none;">[|value] <span style="font-family: 'Arial','sans-serif'; font-size: 20px;"> of something that must be given <span style="color: #000000; font-family: 'Arial','sans-serif'; font-size: 20px; text-decoration: none;">[|up to] <span style="font-family: 'Arial','sans-serif'; font-size: 20px;"> acquire or <span style="color: #000000; font-family: 'Arial','sans-serif'; font-size: 20px; text-decoration: none;">[|achieve] <span style="font-family: 'Arial','sans-serif'; font-size: 20px;"> something else. Since every <span style="color: #000000; font-family: 'Arial','sans-serif'; font-size: 20px; text-decoration: none;">[|resource] <span style="font-family: 'Arial','sans-serif'; font-size: 20px;"> ( <span style="color: #000000; font-family: 'Arial','sans-serif'; font-size: 20px; text-decoration: none;">[|land] <span style="font-family: 'Arial','sans-serif'; font-size: 20px;">, <span style="color: #000000; font-family: 'Arial','sans-serif'; font-size: 20px; text-decoration: none;">[|money] <span style="font-family: 'Arial','sans-serif'; font-size: 20px;">, time, etc.) can be put to alternative <span style="color: #000000; font-family: 'Arial','sans-serif'; font-size: 20px; text-decoration: none;">[|uses] <span style="font-family: 'Arial','sans-serif'; font-size: 20px;">, every <span style="color: #000000; font-family: 'Arial','sans-serif'; font-size: 20px; text-decoration: none;">[|action] <span style="font-family: 'Arial','sans-serif'; font-size: 20px;">, <span style="color: #000000; font-family: 'Arial','sans-serif'; font-size: 20px; text-decoration: none;">[|choice] <span style="font-family: 'Arial','sans-serif'; font-size: 20px;">, or <span style="color: #000000; font-family: 'Arial','sans-serif'; font-size: 20px; text-decoration: none;">[|decision] <span style="font-family: 'Arial','sans-serif'; font-size: 20px;"> has an <span style="color: #000000; font-family: 'Arial','sans-serif'; font-size: 20px; text-decoration: none;">[|associated] <span style="font-family: 'Arial','sans-serif'; font-size: 20px;"> opportunity <span style="color: #000000; font-family: 'Arial','sans-serif'; font-size: 20px; text-decoration: none;">[|cost] <span style="font-family: 'Arial','sans-serif'; font-size: 20px;">. - <span style="font-family: 'Arial','sans-serif'; font-size: 20px;">Example of opportunity cost: when a manufacturing firm decides to invest money to build a plant instead of depositing money to bank with 3% per year. 3% interest rate is the opportunity cost of the decision since the firm has to give up this benefit to have money for new investment.

__** Concept of Time Value of Money **__

<span style="font-family: 'Arial','sans-serif'; font-size: 20px;">Investments commonly involve returns that extend over fairly long period of time. Therefore, in approaching capital budgeting decisions, it is necessary to employ techniques that recognize the time value of money. 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.


 * __ Non-discounting Methods __**

1. Payback Period Method

- <span style="color: #000000; font-family: 'Arial','sans-serif'; font-size: 20px;">Definition: Payback period is the length of time required to recover the <span style="color: #000000; font-family: 'Arial','sans-serif'; font-size: 20px; text-decoration: none;">[|cost] <span style="color: #000000; font-family: 'Arial','sans-serif'; font-size: 20px;"> of an investment. The basic premise of the payback method is that the more quickly the cost of an investment can be recovered, the more desirable is the investment. The payback period is expressed in years. - <span style="color: #000000; font-family: 'Arial','sans-serif'; font-size: 20px;">Formula: When the **net annual cash inflow is the same** every year, the following formula can be used to calculate the payback period:

Payback Period = original investment/annual cash flow

<span style="color: #333333; font-family: 'Arial','sans-serif'; font-size: 20px;">If an investment **involves uneven cash flows**, the computation requires scheduling cash inflows and outflows. The payback period is the point at which the cumulative net cash inflows begin to exceed the cumulative net cash outflows. - <span style="color: #000000; font-family: 'Arial','sans-serif'; font-size: 20px;">Example of payback period: Cornerstone 19.1 <span style="color: #333333; font-family: 'Arial','sans-serif'; font-size: 20px;">Company ABC needs a new sewing machine. The company is considering two machines: Machine A and machine B, both have 4 year life. Machine A costs $15,000 and will create the cash flow of $5,000 per year. Machine B costs only $10,000 but will create the cash flow of $3,000, $5,000, $5,000, $2000. //<span style="color: #333333; font-family: 'Arial','sans-serif'; font-size: 20px;">Required: // //<span style="color: #333333; font-family: 'Arial','sans-serif'; font-size: 20px;">Calculation: // <span style="color: #333333; font-family: 'Arial','sans-serif'; font-size: 20px;">Machine A payback period = original investment/annual cash flow <span style="color: #333333; font-family: 'Arial','sans-serif'; font-size: 20px;">= $15,000 / $5,000 = **__3.0 years__** <span style="color: #333333; font-family: 'Arial','sans-serif'; font-size: 20px;">Machine B payback period = **__2.4 years__** <span style="color: #333333; font-family: 'Arial','sans-serif'; font-size: 20px;">Machine B has shorter payback period and thus seems less risky than machine A, so the company should choose machine B based on payback period method. <span style="color: #333333; font-family: 'Arial','sans-serif'; font-size: 20px;">Machine C payback period = $10,000 / $3,000 = **__3.3 years__** <span style="color: #333333; font-family: 'Arial','sans-serif'; font-size: 20px;">According to payback calculations, the company should purchase machine B, since it has a shorter payback period than machine A and C.  - <span style="color: #000000; font-family: 'Arial','sans-serif'; font-size: 20px;">Advantages of payback period method: - <span style="color: #000000; font-family: 'Arial','sans-serif'; font-size: 20px;">Disadvantages of payback period method: <span style="color: #333333; font-family: 'Arial','sans-serif'; font-size: 20px;">Because of these reasons, other methods of capital budgeting like net present value, internal rate of return or discounted cash flow are generally preferred.
 * <span style="font-family: 'Arial','sans-serif'; font-size: 20px;">Calculate payback period for machine A and B
 * <span style="font-family: 'Arial','sans-serif'; font-size: 20px;">Which machine should be purchased according to payback method?
 * <span style="font-family: 'Arial','sans-serif'; font-size: 20px;">What if a third machine, machine C became available with the same investment as machine B and annual cash flows of $3,000? Which machine would be chosen?
 * **<span style="color: #333333; font-family: 'Arial','sans-serif'; font-size: 20px;">Year ** ||  **<span style="color: #333333; font-family: 'Arial','sans-serif'; font-size: 20px;">Unrecovered investment (beginning of year) **  ||  **<span style="color: #333333; font-family: 'Arial','sans-serif'; font-size: 20px;">Annual cash flow **  ||  **<span style="color: #333333; font-family: 'Arial','sans-serif'; font-size: 20px;">Time needed for payback **  ||
 * <span style="color: #333333; font-family: 'Arial','sans-serif'; font-size: 20px;">1 || <span style="color: #333333; font-family: 'Arial','sans-serif'; font-size: 20px;">$10,000 || <span style="color: #333333; font-family: 'Arial','sans-serif'; font-size: 20px;">$3,000 || <span style="color: #333333; font-family: 'Arial','sans-serif'; font-size: 20px;">1.0 year ||
 * <span style="color: #333333; font-family: 'Arial','sans-serif'; font-size: 20px;">2 || <span style="color: #333333; font-family: 'Arial','sans-serif'; font-size: 20px;">$7,000 || <span style="color: #333333; font-family: 'Arial','sans-serif'; font-size: 20px;">$5,000 || <span style="color: #333333; font-family: 'Arial','sans-serif'; font-size: 20px;">1.0 year ||
 * || <span style="color: #333333; font-family: 'Arial','sans-serif'; font-size: 20px;">$2,000 || <span style="color: #333333; font-family: 'Arial','sans-serif'; font-size: 20px;">$5,000 || <span style="color: #333333; font-family: 'Arial','sans-serif'; font-size: 20px;">0.4 year ||
 * <span style="color: #000000; font-family: 'Arial','sans-serif'; font-size: 20px;">It is a popular and easy method
 * <span style="color: #000000; font-family: 'Arial','sans-serif'; font-size: 20px;">It is valuable when the key investment goal is to find projects where the initial investment is quickly recovered.
 * <span style="color: #000000; font-family: 'Arial','sans-serif'; font-size: 20px;">It ignores any benefits that occur after the payback period and, therefore, does not measure profitability.
 * <span style="color: #000000; font-family: 'Arial','sans-serif'; font-size: 20px;">It ignores the time value of <span style="color: #000000; font-family: 'Arial','sans-serif'; font-size: 20px; text-decoration: none;">[|money] <span style="color: #000000; font-family: 'Arial','sans-serif'; font-size: 20px;">.