In: Accounting
Ekon owns a small tow-truck business that responds to state patrol requests to tow cars involved in wrecks, as well as to private business requests from customers at various auto repair shops and individuals with stalled autos. Ekon’s business is open 24/7 for 365 days a year. He is starting to see too many repairs on his three trucks, which either means that he loses business or must divert a truck from another area. He is now trying to consider whether it is best to continue use of the current trucks or whether he needs to invest some money in new trucks. Using the steps for the process of capital decision-making, create an outline with sub-steps that include questions Ekon can use to guide his investigation or considerations of buying new trucks.
To help reduce the risk involved in capital investment, a process is required to thoughtfully select the best opportunity for the company.
The process for capital decision-making involves several steps:
ANS:
Ekon own a small tow-truck business that provides custom towing
applications for general business use. Your trucks are used daily,
which is good for business but results in heavy wear on each truck.
After some time, and after a few too many repairs, you consider
whether it is best to continue to use the trucks you have or to
invest some of your money in a new set of trucks. A capital
investment decision like this one is not an easy one to make, but
it is a common occurrence faced by companies every day. Companies
will use a step-by-step process to determine their capital needs,
assess their ability to invest in a capital project, and decide
which capital expenditures are the best use of their
resources.
Capital investment (sometimes also referred to as capital
budgeting) is a company’s contribution of funds toward the
acquisition of long-lived (long-term or capital) assets for further
growth. Long-term assets can include investments such as the
purchase of new equipment, the replacement of old machinery, the
expansion of operations into new facilities, or even the expansion
into new products or markets. These capital expenditures are
different from operating expenses. An operating expense is a
regularly-occurring expense used to maintain the current operations
of the company, but a capital expenditure is one used to grow the
business and produce a future economic benefit.
Capital investment decisions occur on a frequent basis, and it is important for a company to determine its project needs to establish a path for business development. This decision is not as obvious or as simple as it may seem. There is a lot at stake with a large outlay of capital, and the long-term financial impact may be unknown due to the capital outlay decreasing or increasing over time. To help reduce the risk involved in capital investment, a process is required to thoughtfully select the best opportunity for the company.
The process for capital decision-making involves several steps:
Determine capital needs for both new and existing projects.
Ekon must first determine its needs by deciding what capital improvements require immediate attention. For example, the company may determine that certain machinery requires replacement before any new buildings are acquired for expansion. Or, the company may determine that the new machinery and building expansion both require immediate attention. This latter situation would require a company to consider how to choose which investment to pursue first, or whether to pursue both capital investments concurrently. Thats why he should find out required capital formation ideas also he can find out that is there any scope to updation in current trucks.
Identify and establish resource limitations.
The second step, exploring resource limitations, evaluates the company’s ability to invest in capital expenditures given the availability of funds and time. Sometimes a company may have enough resources to cover capital investments in many projects. Many times, however, they only have enough resources to invest in a limited number of opportunities. If this is the situation, the company must evaluate both the time and money needed to acquire each asset. Time allocation considerations can include employee commitments and project set-up requirements. Fund limitations may result from a lack of capital fundraising, tied-up capital in non-liquid assets, or extensive up-front acquisition costs that extend beyond investment. Once the ability to invest has been established, the company needs to establish baseline criteria for alternatives.
Resource Limitations
Time Considerations= Employee commitments,
Project set-up, Time-frame necessary to secure financing
Money Considerations= Lack of liquidity,Tied up in non-liquid assets, Up-front acquisition costs
When resources are limited, capital budgeting procedures are needed.
Establish baseline criteria for alternatives.
Alternatives are the options available for investment. For example, if a company needs to purchase new truck, all possible equipment options are considered alternatives. Since there are so many alternative possibilities, a company will need to establish baseline criteria for the investment. Baseline criteria are measurement methods that can help differentiate among alternatives. Common measurement methods include the payback method, accounting rate of return, net present value, or internal rate of return. These methods have varying degrees of complexity and will be discussed in greater detail in Evaluate the Payback and Accounting Rate of Return in Capital Investment Decisions and Explain the Time Value of Money and Calculate Present and Future Values of Lump Sums and Annuities.
Evaluate alternatives using screening and preference
decisions.
To evaluate alternatives, businesses will use the measurement methods to compare outcomes. The outcomes will not only be compared against other alternatives, but also against a predetermined rate of return on the investment (or minimum expectation) established for each project consideration. The rate of return concept is discussed in more detail in Balanced Scorecard and Other Performance Measures. A company may use experience or industry standards to predetermine factors used to evaluate alternatives. Alternatives will first be evaluated against the predetermined criteria for that investment opportunity, in a screening decision. The screening decision allows companies to remove alternatives that would be less desirable to pursue given their inability to meet basic standards. For example, if there were three different truck options and a minimum return had been established, any trucks that did not meet that minimum return requirement would be removed from consideration.
Make the decision.
If one or more of the alternatives meets or exceeds the minimum expectations, a preference decision is considered. A preference decision compares potential projects that meet screening decision criteria and will rank the alternatives in order of importance, feasibility, or desirability to differentiate among alternatives. Once the company determines the rank order, it is able to make a decision on the best avenue. When making the final decision, all financial and non-financial factors are deliberated.
Select Between Alternatives. Screening and preference decisions can narrow alternatives in making a selection.
These steps make it seem as if narrowing down the alternatives and
making a selection is a simple process. However, Akon needs to use
analysis techniques, including the payback method and the
accounting rate of return method, as well as this, more
sophisticated and complex techniques, to help them make screening
and preference decisions. These techniques can assist management in
making a final investment decision that is best for the
company.