12.1Introducing Capital Budgeting
J: I have here a special little machine.
K: OK, what does it do?
J: It creates money.
K: Money? How much money?
J: This little machine here creates exactly one U.S. dollar per year. Completely legal. The dollar bill pops out this hole at midnight on December 31 every year.
K: Are you sure this is legal?
J: Absolutely. – Now, the question is: How much would you pay me to buy this dollar bill machine?
K: How long is it going to last?
J: That’s the good news. This little machine is guaranteed to last ONE BILLION YEARS. Yes, in its useful lifetime this machine will produce a total of ONE BILLION DOLLARS.
K: A billion dollars? Wow.
J: So, how much will you pay me for this machine, this billion-dollar machine? Will you pay me a billion dollars for it?
K: Well, uhh, no.
J: Why not? You will completely recover your billion-dollar investment over the life of this machine. You pay me a billion dollars for it now, and you will eventually get your entire billion dollars back.
K: Yeah, but I’ll have to wait a billion years!! Plus, a dollar now is worth a lot more than a dollar a billion years from now.
J: EXACTLY!!!! You have hit on the KEY concept here. It is called the TIME VALUE OF MONEY. A dollar now is worth more than a dollar to be received 5 years from now, or 30 years from now, or a billion years from now. So, when you are evaluating long-term projects (a process called CAPITAL BUDGETING), you have to consider the time value of money.
K: OK, so what would be a fair price for your billion-dollar machine?
J: Let’s say that an appropriate interest rate is 10%. Is that OK?
K: Sure, 10%.
J: If the interest rate is 10%, then an appropriate price for this billion-dollar machine is … $10.
K: Ten dollars!!! For a billion-dollar machine?
J: Yes, the PRESENT VALUE of $1 per year for a billion years, if the INTEREST RATE is 10%, is $10.
K: OK, so what if the price of your little machine is $12. Should I buy it?
J: No. This is an illustration of CAPITAL BUDGETING, making long-term decisions. You compare the PRESENT VALUE of the cash INFLOWS from a project to the PRESENT VALUE of the cash OUTFLOWS associated with the project.
K: If the purchase price is $12, then the cash OUTFLOW is $12. And if I have to pay that now, it is easy to compute the PRESENT VALUE: a $12 payment NOW has a PRESENT VALUE of $12.
J: Correct. And the PRESENT VALUE of the cash INFLOWS is $10, the PRESENT VALUE of $1 per year for a billion years, if the interest rate is 10%.
K: The PRESENT VALUE of the cash OUTFLOWS, $12, is greater than the PRESENT VALUE of the cash INFLOWS, $10, to that is a bad deal.
J: Right. Don’t buy the machine. That is an illustration of CAPITAL BUDGETING, making long-term decisions.