Determining the Value of Large Expenditures

Business decisions surrounding large expenditures are often key to whether the enterprise will thrive or struggle. An entrepreneur’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 capital budgeting analysis to assure efficient allocation of resources.

Whether It Makes Sense

Feasibility of capital expenditures is a function of money as well as time. Your capital budgeting process begins by ranking large purchases in their order of priority. This is how you decide when projects will be undertaken and the capital 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 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. Moreover, these techniques 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. Another drawback to considering only payback is the failure to consider profitability over the long-term. A fast payback might not ultimately generate much profit. Alternatively, a slow payback could disguise a vastly profitable undertaking over the life of the investment.

Quantifying the Benefit

Discounted cash flow models are frequently utilized to identify the current value of a major purchase. The Net Present Value method estimates all the future cash inflows and outflows. For instance, cash inflow is the revenue expected from investing in a new piece of equipment; 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 the future to bring us the same happiness as a lower sum today. Getting started with net present value determinations using discount rates is usually accomplished with the help of a financial pro until you get the hang of it.

A positive net present value indicates the equipment will earn more than the discount rate. Even if the figure is negative, the equipment may still provide profitability…but 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.

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