Behaving better with profit sharing

Chapter 16 Using Capital Budgeting to Prepare for the Future

In This Chapter

▶ Preparing for capital investments ▶ Determining capital’s cost ▶ Choosing the best capital investments

Purchasing machinery and equipment and building factories require spending today in order to receive future revenue. Thus, capital budgeting is one of the most important and yet uncertain decision-making areas because it’s critically influenced by time.

Capital budgeting decisions require a substantial amount of forecasting — I hope you have your crystal ball or Magic 8 ball handy. Biased or poorly developed forecasts adversely affect the quality of investment decisions. Therefore, techniques for evaluating capital investment projects have limited value in the absence of unbiased, well-developed forecasts.

In this chapter, I show you the critical components for evaluating alternative investment projects and selecting from them. That process includes understanding critical aspects of estimating future cash flows and procedures for determining the cost of capital. Understanding these critical components provides the foundation for comparing and evaluating alternative investment projects.

Investing in Capital

Economists define capital as the machinery, equipment, and factories you use in the production process. Investment refers to the purchasing of capital.

To an economist, buying stock on the New York Stock Exchange isn’t investment because you’re not buying an actual machine or building a factory.