CAPITAL INVESTMENTS: MODELS USED IN DECISION MAKING
Capital investments are long-term investments made by companies to eventually
enhance proﬁtability and shareholder value. Capital investments normally last a company for a number of years, and they take longer periods of time to implement or enhance within an organization. Some examples of capital investments include, but are not limited too: automation in factories (equipment and software), research and development, equipment to improve quality control, software to test productivity measures, etc. These investments include a great deal of labor, capital and time to implement. Since capital investments can be risky, meaning any losses will be large to the organization considering the amount of time and capital involved, organizations have a process to determine what capital investments they should get involved in, and why. Capital investment decisions are concerned with the process of planning, setting
goals and priorities, arranging ﬁnancing and using certain criteria to select long-term assets. (“Hansen & Mowen,” 2011) Companies may start by listing all the improvements that are to be made to affect proﬁtability in the long run. Since these improvements will consume large amounts of time and capital, it is not feasible for companies to make multiple investments at a time. To assist in deciding which investment to take on ﬁrst, the company must calculate which will be the most proﬁtable and increase shareholder value. This is done by a process called capital budgeting, which tells the company what
project to start on and when. ("Evaluating business investments," 2012) Looking deeper in the process implemented by organizations to make capital
budgeting decisions, some of the research that should be done ﬁrst includes - ("Food and agriculture," 2011) • a formulation of long-term goals, a vision of what the organization is trying to achieve • research of new investment opportunities which would be inline with the organizationʼs strategic plan • proposals made of several identiﬁed projects, with the consideration of capital and length of time required • the proposals for each project must include a forecast of current and future cash ﬂows • the proposals must also include an estimation of expenditures and capital required for each project • and an estimation of return of capital for each project** **There are several models organizations use to make capital investment decisions, which will be discussed next.
The two models organizations use to assist in making capital investment
decisions are Discounting and Nondiscounting models. (“Hansen & Mowen,” 2011) The main difference between the two models is their consideration for time value of money. With this difference in mind, most organizations use both models before making capital investment decision, because both models reveal different and useful information when considering an investment. This information is going to be discussed next.
Nondiscounting models ignore the time value of money, Still widely used, this
model seems to loose itʼs popularity amongst many accountants and controllers. There are two types of Nondiscounting models to discuss -
1. Payback Period - As the name implies, the Payback Period calculates the amount of time it takes for a capital budgeting project to recover its initial cost. An easier way to think of this concept is comparing it to the break even point in the project. It uses a general rule of thumb that capital investments with the least Payback Period should be considered. (Lane, 2005) One strategy that organizations may use is to set the maximum number of years during which the organization would like to recoup its original investment, and use that as a threshold when considering the capital investment projects being discussed. If the project has a payback period longer than the maximum established, then it...