Question

Arrange to speak to someone in the Finance Department at your organization. Discuss with this individual how the organization uses the concept of "time value of money" to plan for the purchase of new equipment. For equipment purchases, how is "useful life" determined and is the same methodology used when calculating depreciation?

Answer 1

Concept:

As the time progresses, money gets depreciated. If a person receives $1 today, it is more worthy than such $1 is receiving in future. Purchasing equipment is a capital budgeting process, where the cost of equipment along with its installation is the present value; the equipment gives future returns with continuing production; all such future returns are converted into present value with an appropriate discount factor (time value of money); the aggregate of these if increases over the cost then the equipment is recommended to purchase.

In this process, three factors are considered:

1) Opportunity: Time value of money gives idea in various investment opportunities. Suppose there are three equipments but an investor can invest only in one because of limited resources; in such case the equipment giving the highest net present value should be considered.

2) Reliability: It gives reliability in evaluation, because present is more reliable than future uncertainty.

3) Inflation: Time value of money becomes central because of evaluating inflation, which is the main economic indicator. Inflation affects in price level, exchange rate, GDP, and unemployment rate. Capital budgeting depends on inflation rates.

Useful life: It comes out of the past experience and the equipment specification. The past experience suggests that the same machine was used earlier and it was having such and such life. If the equipment has specification that it will be used for certain specific life, then such life should be taken for consideration.

Depreciation: This is the wear and tear of an asset. It depends on the useful life; the whole value of asset (cost + Installation) should be recovered within the entire life of the equipment, so that at the end of such life new equipment could be purchased without any hassle.