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11.1: Prelude to Capital Budgeting Decisions

  • Page ID
    5248
  • Jerry Price owns Milling Manufacturing, a production facility geared toward entrepreneurial product development. Initially, Jerry purchased several milling machines, but after seven years, the machines have become obsolete due to technological advances. Jerry must purchase new machines to continue business growth, and there are several options available. How does he choose the best machines for his business? What factors must he consider before purchase?

    A picture of precision machined metal plates with many holes of differing sizes.
    Figure \(\PageIndex{1}\): Milling Manufacturing. Long-term project investment requires careful capital budgeting analysis. (credit: modification of “Parts for CNC Machine” by Andy Malmin/Flickr, CC BY 2.0)

    Jerry must consider several important factors—both financial and non-financial—as he makes this decision. First, he needs to consider the commitment of his initial capital investment. He also needs to compare differences between options such as warranties, the production capacities of different machines, and maintenance and repair costs. Another factor is the useful life of the new equipment—in other words, both its physical and the technological life. He will also consider how long it will take to recoup the cost of the investment, the impact on cash flow, and how the passage of time affects the value of the asset to the organization—it’s monetary value that considered depreciation to determine what the asset is actually worth to the organization in terms of dollars (i.e., “what could we sell it for?”). Jerry will consider the value of the dollar invested today in purchasing the machine as opposed to the value of the dollar in the future that might be better spent on another project. This last factor is significant because the new equipment will probably provide part of his down payment on future replacement equipment. There are also nonfinancial factors to consider, such as changes to customer satisfaction and employee morale.

    Jerry knows this equipment choice goes well beyond color or price preferences. The decision has a long-lasting influence on company direction and opportunity, and he needs to utilize capital budgeting analysis to help him make this decision.