Of Capital Investments

4.3.1 Capital Investment Characteristics

When companies spend money, the outlay of cash can be broadly categorized into one of two classifications; expenses or capital investments. Expenses are generally those cash expenditures that are routine, ongoing, and necessary for the ordinary operation of the business. Capital investments, on the other hand, are generally more strategic and have long term effects. Decisions made regarding capital investments are usually made at higher levels within the organizational hierarchy and carry with them additional tax consequences as compared to expenses.

Three characteristics of capital investments are of concern when performing life cycle cost analysis. First, capital investments usually require a relatively large initial cost. "Relatively large" may mean several hundred dollars to a small company or many millions of dollars to a large company. The initial cost may occur as a single expenditure such as purchasing a new heating system or occur over a period of several years such as designing and constructing a new building. It is not uncommon that the funds available for capital investments projects are limited. In other words, the sum of the initial costs of all the viable and attractive projects exceeds the total available funds. This creates a situation known as capital rationing which imposes special requirements on the investment analysis. This topic will be discussed in Section 4.8.3.

The second important characteristic of a capital investment is that the benefits (revenues or savings) resulting from the initial cost occur in the future, normally over a period of years. The period between the initial cost and the last future cash flow is the life cycle or life of the investment. It is the fact that cash flows occur over the investment's life that requires the introduction of lime value of money concepts to properly evaluate investments. If multiple investments are being evaluated and if the lives of the investments are not equal, special consideration must be given to the issue of selecting an appropriate planning horizon for the analysis. Planning horizon issues are introduced in Section 4.8.5.

The last important characteristic of capital investments is that they are relatively irreversible. Frequently, after the initial investment has been made, terminating or significantly altering the nature of a capital investment has substantial (usually negative) cost consequences. This is one of the reasons that capital investment decisions are usually evaluated at higher levels of the organizational hierarchy than operating expense decisions.

4.3.2 Capital Investment Cost Categories

In almost every case, the costs which occur over the life of a capital investment can be classified into one of the following categories:

• Annual Expenses and Revenues,

• Periodic Replacement and Maintenance, or

As a simplifying assumption, the cash flows which occur during a year are generally summed and regarded as a single end-of-year cash flow. While this approach does introduce some inaccuracy in the evaluation, it is generally not regarded as significant relative to the level of estimation associated with projecting future cash flows.

Initial costs include all costs associated with preparing the investment for service. This includes purchase cost as well as installation and preparation costs. Initial costs are usually nonrecurring during the life of an investment. Annual expenses and revenues are the recurring costs and benefits generated throughout the life of the investment. Periodic replacement and maintenance costs are similar to annual expenses and revenues except that they do not (or are not expected to) occur annually. The salvage (or residual) value of an investment is the revenue (or expense) attributed to disposing of the investment at the end of its useful life.

4.3.3 Cash Flow Diagrams

A convenient way to display the revenues (savings) and costs associated with an investment is a cash flow diagram. By using a cash flow diagram, the timing of the cash flows are more apparent and the chances of properly applying time value of money concepts are increased. With practice, different cash flow patterns can be recognized and they, in turn, may suggest the most direct approach for analysis.

It is usually advantageous to determine the time frame over which the cash flows occur first. This establishes the horizontal scale of the cash flow diagram. This scale is divided into time periods which are frequently, but not always, years. Receipts and disbursements are then located on the time scale in accordance with the problem specifications. Individual outlays or receipts are indicated by drawing vertical lines appropriately placed along the time scale. The relative magnitudes can be suggested by the heights, but exact scaling generally does not enhance the meaningfulness of the diagram. Upward directed lines indicate cash inflow (revenues or savings) while downward directed lines indicate cash outflow (costs).

Figure 4.2 illustrates a cash flow diagram. The cash flows depicted represent an economic evaluation of whether to choose a baseboard heating and window air conditioning system or a heat pump for a ranger's house in a national park [Fuller and Petersen, 1994]. The differential costs associated with the decision are:

• The heat pump costs (cash outflow) $1500 more than the baseboard system,

• The heat pump saves (cash inflow) $380 annually in electricity costs,

• The heat pump has a $50 higher annual maintenance costs (cash outflow),

• The heat pump has a $150 higher salvage value (cash inflow) at the end of 15 years,

• The heat pump requires $200 more in replacement maintenance (cash outflow) at the end of year 8.

Although cash flow diagrams are simply graphical representations of income and outlay, they should exhibit as much information as possible. During the analysis phase, it is useful to show the Minimum Attractive Rate of Return (an interest rate used to account for the time value of money within the problem) on the cash flow diagram, although this has been omitted in Figure 4.2. The requirements for a good cash flow diagram are completeness, accuracy, and legibility. The measure of a successful diagram is that someone else can understand the problem fully from it.

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