Capital Investment Decisions

6559 WordsDec 15, 201127 Pages
PURDUE EXTENSION EC-731 Capital Investment Analysis and Project Assessment Michael Boehlje and Cole Ehmke Department of Agricultural Economics Capital investment decisions that involve the purchase of items such as land, machinery, buildings, or equipment are among the most important decisions undertaken by the business manager. These decisions typically involve the commitment of large sums of money, and they will affect the business over a number of years. Furthermore, the funds to purchase a capital item must be paid out immediately, whereas the income or benefits accrue over time. Because the benefits are based on future events and the ability to foresee the future is imperfect, you should make a considerable effort to evaluate…show more content…
Based on this return, if the manager invests $681 today, then the investment will be worth $1,000 in five years (Table 1). Table 1. Time Value of Money Year Value Beginning of Year Interest Rate Annual Interest Amount at End of Year year for the next five years. The discount factor for money received at the end of the first year, assuming an 8% rate, is 0.9259. You can find the discount factor of 0.9259 in the appendix at the point where year one and 8% meet. Hence, the $1,000 received at the end of the first year has a present value of only $925.90 ($1,000 x 0.9259). In similar fashion, you can calculate the present value of the $1,000 received at the end of years two through five using the discount factors from the appendix for 8% and the appropriate years. You can then determine the present value of this flow of money as the sum of the annual present values. So the present value of an annual flow of $1,000 for each of five years (assuming an 8% discount rate) is only $3,992.60. As a manager, you would be equally well off if you were to receive a current payment of $3,992.60 or the annual payment of $1,000 per year for five years, assuming an 8% discount rate. In essence, discounting reverses the compounding process and converts a future sum of money to a current sum by discounting or penalizing it for the fact that you don’t have it now, but have to wait to get it and consequently give up any earnings you could obtain if
Open Document