﻿ ﻿Capital Budgeting in a Nutshell - Financial Management - QuickBooks 2016 All-in-One For Dummies (2016)

# QuickBooks 2016 All-in-One For Dummies (2016)

### Financial Management

See www.dummies.com/extras/quickbooks2016aio for a compendium of financial ratios.

Contents at a Glance

1. Chapter 1: Ratio Analysis

1. Some Caveats about Ratio Analysis

2. Liquidity Ratios

3. Leverage Ratios

4. Activity Ratios

5. Profitability Ratios

2. Chapter 2: Economic Value Added Analysis

1. Introducing the Logic of EVA

2. Seeing EVA in Action

3. Reviewing Some Important Points about EVA

5. Presenting Two Final Pointers

6. And Now, a Word to My Critics

3. Chapter 3: Capital Budgeting in a Nutshell

1. Introducing the Theory of Capital Budgeting

2. Calculating the Rate of Return on Capital

3. Measuring Liquidity

5. What Does All This Have to Do with QuickBooks?

### Capital Budgeting in a Nutshell

In This Chapter

· Understanding the theory of capital budgeting

· Computing the rate of return on capital

· Taking the measure of liquidity

· Contemplating risk

· Relating capital budgeting to QuickBooks

The challenge for any business is allocating capital, or money. Although you have limited amounts of capital, your ideas and opportunities are often unlimited.

Capital budgeting, in a nutshell, helps you to sift through all these ideas and opportunities. Capital budgeting lets you answer questions like the following: Should I replace that key piece of machinery that we use in the factory or get a new delivery truck? Should we buy the building our offices are in? Or should we purchase that competitor’s operation because it’s for sale?

Introducing the Theory of Capital Budgeting

Capital budgeting boils down to the idea that you should look at capital investments (machinery, vehicles, real estate, entire businesses, yard art, and so on) just as you look at the certificates of deposit (CDs) that a bank offers.

Don’t worry — you actually already know how to do this. When you buy a bank CD, you essentially look at one big thing and then a couple of small things in order to decide whether a CD makes sense. The big thing is the interest rate. The two small things are the CD maturity and the risk. In the next couple of sections, I talk a bit about all three things because they apply so neatly to the problem and challenge of capital budgeting.

The big thing is the return

The big thing, as I just mentioned, is the interest rate that a CD pays. You want to earn the highest return possible on your money. Therefore, you want a CD that pays a high interest rate! A 4 percent interest rate is better than a 2 percent interest rate. And a 6 percent interest rate is way better than a 4 percent interest rate.

You can also look at the interest rates earned on capital investments. Before I go any further, though, you should know that interest rates typically don’t go by that name in capital investing. For some strange reason, the interest rate that a capital investment (like a piece of machinery, vehicle, or real estate) earns is called a return on investment, or a rate of return. But it’s the same thing. The rate of return or return on investment (ROI) is really just the interest rate that a capital investment or capital expenditure pays.

The return is important because it shows the profitability of the investment, albeit as a percentage of the investment. The first thing you need to know about the theory of capital budgeting is that the big thing that matters is the return.

One little thing is maturity

The first little thing that you also look at in the case of a CD is the maturity. The maturity simply refers to the amount of time that your money gets tied up in the investment. For example, you may not want a one-month CD. That short maturity means you have to roll over or reinvest the CD at a new, perhaps lower, rate of return in a month. On the other hand, you may also want to avoid tying up your money for a long period, such as 40 years. Tying up your money for a very long time period means that you won’t be able to get to the money if a new, better opportunity comes along. You probably see very few opportunities that are so good, so surefire, so long-term that they warrant tying up your money for decades and decades, right?

In the case of capital investments, you don’t actually use the word maturity in most situations. Instead, you should use a term called liquidity, which simply means how close an investment is to cash or how quickly an investment returns or pays back the cash that you’ve invested.

You can measure liquidity in a bunch of ways. A little later in the chapter, I talk about one simple approach to measuring liquidity: the payback period. The key thing to remember about liquidity is this: Liquidity isn’t as important as the return on investment. Remember, the return shows profitability. Nevertheless, you do want to think about the liquidity of a capital investment. What you think depends on your circumstances. In different circumstances, you prefer capital investments with different degrees of liquidity.

Another little thing is risk

With CDs, government insurance programs such as the Federal Deposit Insurance Corporation (FDIC) reduce the risk of investing. But the risks still matter, right? If you’re over the limits of insurance coverage, you don’t put all your money in the same bank. Even if you’re under the FDIC insurance limits, you don’t put money in a bank that’s at risk of going under. Do that, and you’ll have the hassle of getting your money back.

Typically, you also carefully select CD-like investments, such as debentures, which some finance companies offer to CD investors. Again, that makes sense. Risk — the chance that maybe you won’t be repaid or that maybe not all your interest will be repaid — is one of the things that you want to consider when you talk about CDs.

In the same way that risk matters to CDs, risk matters to capital investments. In fact, risk probably matters more in the latter case. No government agency guarantees that some capital investment will deliver the returns that you plan on. For this reason, you must consider the risk of capital investments. You can consider risk both quantitatively (which means using measurements that produce values that measure the risk) and qualitatively (which means relying on your gut).

The bottom line

The bottom line is this: You actually already know the theory of capital budgeting; it works like picking a CD down at the local bank. You want to look at the profitability of the investment by somehow measuring the return on the investment, or the interest rate. However, profitability isn’t the only consideration. If you look at a capital expenditure, you also consider the liquidity of the investment. Likewise, you take into account the risk of the investment.

Stated in a slightly different way, when you make capital investments, you want to invest in things that pay the highest return. But you also want to recognize the importance of liquidity, not to mention the risk. You get the theory now, right?

The difference with capital budgeting, then, is that you (rather than the bank issuing the CD) need to calculate the return, quantify or measure the liquidity, and think carefully about the risks. That’s really it. You just do those three additional things, which — surprise, surprise — I discuss next in this chapter.

Calculating the Rate of Return on Capital

I can tell you right up front that calculating the rate of return on a capital investment is a little bit tricky. In almost every case, you need either a financial calculator (a good one) or a spreadsheet program, such as Microsoft Excel. For the purpose of this discussion, I assume that you have (or have access to) Microsoft Excel. If you don’t have Excel, you should still be able to read almost all the following discussion and then translate what I talk about into the instructions that you need in order to use a financial calculator or some other spreadsheet program. Note that the spreadsheet mechanics that I describe aren’t very difficult.

If you aren’t all that comfortable with the notion of using Microsoft Excel — even though it’s already installed on your computer — check out Appendix A in Book VIII. It provides a crash course on Excel. You may also want to think about getting a copy of Excel For Dummies, by Greg Harvey. Just make sure you pick up the edition that talks about your specific version of Excel. For example, if you’re running Excel 2013, make sure that you get Excel 2013 For Dummies.

Calculating a rate of return on a capital expenditure requires three steps:

1. Calculate the investment amount.

2. Estimate the net cash flows paid by the investment.

3. Use a financial calculator (such as one of those fancy Hewlett-Packard calculators) or a spreadsheet program (such as Microsoft Excel) to calculate the rate of return measure.

In the next sections, I explain each of these steps.

If you can, use a spreadsheet program rather than go the fancy-calculator route; such calculators can be less than user-friendly. Slightly more than three decades ago, when I was graduating with an MBA in Finance from the University of Washington, the joke among many young MBAs was that the ability to calculate the rate of return measures on a Hewlett-Packard 12C calculator was worth \$40,000 a year. The slogan, in fact, was “40G for a 12C.”

Calculating the investment amount

The first step in calculating a return is estimating the amount that you need to invest. This amount is similar to the check you write to a bank in order to buy a CD.

Suppose that you’re considering the purchase of a new office building. Just to keep everything really simple, suppose that you can buy a building that would house your offices for \$350,000. Further suppose that you can finance \$300,000 of this purchase with a mortgage from your friendly local bank. However, you also need to pay closing costs that equal \$15,000.

Table 3-1 shows the initial investment that you must make in order to invest in a new office building. The bottom-line amount is \$65,000. The table shows how this amount gets calculated. The formula is pretty simple: The building costs \$350,000, and you must pay \$15,000 in closing costs. That totals \$365,000. The bank, however, will finance \$300,000 of this amount. This means that you need to come up with \$65,000 out of your own pocket.

Table 3-1 Calculating the Investment

 Price of building \$350,000 Less: Mortgage 300,000 Down payment 50,000 Add: Closing costs 15,000 Total initial investment \$65,000

Make sure that you understand why the initial investment, or the first check that you need to write, is \$65,000. This is the investment that you make in the building.

Estimating the net cash flows

The process of estimating the net cash flows from the investment requires a bit more work than the previous exercise did. Sit down and think carefully about any additional revenues and any additional costs that the investment produces. Obviously, you hope that the net effect of the investment will save you cash. However, certain amounts of the investment will cost you. On the other hand, you also receive savings that the investment returns.

You want to construct a little schedule — this can be written on the back of a cocktail napkin or typed in a spreadsheet program like Excel — and use it to carefully estimate and calculate cash flows.

Suppose, in the case of the office building, that the following two items determine the net cash flows:

· The new mortgage requires an annual \$21,000 interest payment. To keep things simple (don’t worry about principal amortization just yet), suppose that this mortgage is interest only. Further suppose that you need to pay the entire mortgage balance in 20 years as part of a balloon payment. In the meantime, however, you’ll pay \$21,000 at the end of every year.

· Because you own your own building, you save \$20,000 in rent the first year. This amount, however, increases every year. If the rent that you’ve been paying has increased every year by 3 percent because of inflation, you may want to assume that your rent savings, in order to be accurately forecasted, should be inflated by 3 percent every year as well. For example, you may want to assume that in the second year, your rent savings equal 103 percent of \$20,000. In the third year, your rent savings equal 103 percent of \$20,600 (which is the second year’s rent savings).

Does this business of rent savings make sense? With capital expenditure investment, the capital investment often saves you money in some way. Therefore, you need to estimate those savings over the years that you’ll use the capital investment. In this case, the rent savings should be equal to the current rent savings plus inflation for each year. Another way to look at the rent savings amount is to say that the rent savings equals the rent that you won’t have to pay if you own the building.

Table 3-2 summarizes the cash flows that you enjoy by investing in this building. The table has a column for each year number. (The schedule shows 20 years of rent savings and mortgage payments.) The schedule also includes three columns, which report on the rent savings, the annual mortgage interest payment, and the net cash flow amount. The net cash flow amount equals the rent savings minus the mortgage interest payment. Notice that in the first two years, the mortgage interest payment exceeds the rent savings. However, in year 3 and beyond, the rent savings exceeds the mortgage payment.

Table 3-2 Summary of Building Cash Flows

 Year Rent Savings Mortgage Payment Net Cash Flows 1 20,000 21,000 -1,000 2 20,600 21,000 -400 3 21,218 21,000 218 4 21,855 21,000 855 5 22,511 21,000 1,511 6 23,186 21,000 2,186 7 23,882 21,000 2,882 8 24,598 21,000 3,598 9 25,336 21,000 4,336 10 26,096 21,000 5,096 11 26,879 21,000 5,879 12 27,685 21,000 6,685 13 28,516 21,000 7,516 14 29,371 21,000 8,371 15 30,252 21,000 9,252 16 31,160 21,000 10,160 17 32,095 21,000 11,095 18 33,058 21,000 12,058 19 34,050 21,000 13,050 20 35,072 21,000 14,072

Just to make sure you understand the information shown in Table 3-2, take a peek at the information estimated for year 17. What does it mean? For year 17, the schedule shows that the rent savings equal \$32,095. In other words, this schedule estimates that in year 17 of building ownership, you save \$32,095 by owning the building. This is the amount that you’re guessing you would have had to pay in rent to a landlord had you not purchased the building. You also have to pay \$21,000 in interest on that \$300,000 mortgage in year 17. The net savings that you accrue, which is the net cash flow in year 17, equals \$11,095. This is simply the net amount left over from the rent savings after paying the mortgage interest.

I need to add one other important wrinkle to the information shown in Table 3-2. When you look at the cash flows that stem from a capital investment, you need to make some assumption about what happens at the end of the investment’s life. In the case of the building investment, for example, you probably need to show that the mortgage is paid off. You also may want to show the sale of the building at some point.

To show you how this works, suppose that at the end of year 20, you pay off the mortgage (which will still be \$300,000 because you have been paying only interest), and suppose that you sell the building for \$630,000. This amount is an estimate. To come up with this estimate, I took the original \$350,000 purchase price and then annually inflated that amount by 3 percent over 20 years. Doing so produces an estimated sale price in year 20 of \$630,000. You’ll also pay selling costs that total \$30,000.

Table 3-3 shows how these numbers produce a final, liquidation cash flow. The gross sales price equals \$630,000, as mentioned earlier. Then you have to pay the \$300,000 mortgage. You also have \$30,000 in selling costs. If you subtract the mortgage and the selling costs from the gross sales price, the final cash flow, then, equals \$300,000. This makes sense, right? The gross sales price of \$630,000 minus \$300,000 for the mortgage payment minus \$30,000 for selling costs equals \$300,000.

Table 3-3 Estimating the Liquidation Cash Flow

 Gross sale price \$630,000 Less: Mortgage 300,000 Less: Selling costs 30,000 Final cash flow from sale \$300,000

The final step is to combine the information shown in Tables 3-2 and 3-3. Table 3-4 does this. The net cash flows column summarizes the net cash flows from Table 3-2. The liquidation cash flow column shows 0 during the first 19 years. In year 20, however, the liquidation cash flow shows as \$300,000. The real deal combines the net cash flows and the liquidation cash flow.

Table 3-4 Combining All Cash Flows

 Year Net Cash Flows Liquidation Cash Flow The Real Deal 1 -1,000 0 -1,000 2 -400 0 -400 3 218 0 218 4 855 0 855 5 1,511 0 1,511 6 2,186 0 2,186 7 2,882 0 2,882 8 3,598 0 3,598 9 4,336 0 4,336 10 5,096 0 5,096 11 5,879 0 5,879 12 6,685 0 6,685 13 7,516 0 7,516 14 8,371 0 8,371 15 9,252 0 9,252 16 10,160 0 10,160 17 11,095 0 11,095 18 12,058 0 12,058 19 13,050 0 13,050 20 14,072 300,000 314,072

Just to make sure that you understand the real deal column’s numbers, I’ll go into detail about a couple of them. Start by looking at year 5. For year 5, the table shows a net cash flow of \$1,511, no liquidation cash flow, and an actual cash flow to you, the business owner, of \$1,511. If this building weren’t a building but was really a CD, this is the amount of interest that the CD would pay you for year 5.

In year 20, things look a bit different. The net cash flow equals \$14,072 when you combine the rent savings and the mortgage interest. The sale of the building at the end of the year also produces a \$300,000 cash flow. This is actually the amount that you’d receive from the escrow company after the sale of the building closes. The net or final cash flow that you receive, then, combines these two amounts: the \$14,072 of net cash flow and the \$300,000 of liquidation cash flow. This cash flow is like the accrued interest being paid back by the bank on a CD.

And now the hard part is done. You essentially turned your building investment into just another set of cash flows. These cash flows look to a financial calculator or spreadsheet program like just another investment. In fact, these cash flows could describe some crazy 20-year CD investment. In this case, of course, they describe an imaginary building investment. But they could be the cash flows from any investment: a new piece of machinery, a corporate jet, or a new delivery truck.

Calculating the return

As I mention previously in this chapter, I’m going to show you the two basic ways that you can calculate a return by using Microsoft Excel. (I use Excel because it’s so ubiquitous.) You can, however, use another spreadsheet program, such as Google Docs, Apache OpenOffice Calc, or any high-powered financial business calculator. Basically, if you understand the logic of the stuff described here, you should be able to translate what I say into Lotus 1-2-3 speak or Hewlett-Packard business calculator speak.

To calculate a rate of return with Microsoft Excel, you first enter the cash flows produced by the investment. In Figure 3-1, I’ve created a simple Excel worksheet that does just this. Even if you’ve never used Excel before, you may be able to construct this worksheet; all you have to do is start Excel (the same way you start any other Windows program). Then you enter the cash flows shown for the building investment. Actually, you enter only the values shown in cells B2, B3, B4, B5, and so on, through cell B22. These values are the cash flow numbers calculated and summarized in Table 3-4 earlier in this chapter. (Flip back and look at Table 3-4 if you don’t see this clearly.)

Figure 3-1: A simple Excel worksheet that shows investment cash flows.

By the way, in case you’re new to Excel, all you do to enter one of these values is click the box (technically called a cell), and then type the value. For example, to enter the initial investment required to buy the building — \$65,000 — you click the B2 cell and then type -65000. After you type this number, press Enter. You enter each of the other net cash flow values in the same manner in order to make the rate-of-return calculations.

I also put in values to label the years and then added a little bit of text in A1 and B1 to identify what the labels are. However, you don’t have to enter those extraneous bits of information.

After you provide the cash flow values of the investment, you tell Excel the rate of return that you want calculated. In Figure 3-1, I actually calculate two rates of return. In Cell G4, for example, I calculate an internal rate of return. An internal rate of return (IRR) is the interest rate that the investment delivers. For example, a CD that pays an 11 percent interest rate pays an 11 percent internal rate of return. To calculate an internal rate of return, you enter an internal rate of return function formula into a worksheet cell. In the case of the worksheet shown in Figure 3-1, for example, you click cell G4 and then type the following:

=IRR(B2:B22,.1)

If you’ve never seen an Excel function before, this probably looks like Greek. But all this function does is tell Excel to calculate the internal rate of return for the cash flows stored in the range, or block of cells, that goes from cell B2 to cell B22. The .1 is my initial guess about the IRR; you provide that value so that Excel has a starting point for calculating the return. The office-building cash flows, it turns out, produce an internal rate of return equal to 11 percent. This means that essentially, the office building delivers an 11 percent interest rate annually on the amounts invested in it.

Another common rate of return measure is something called a net present value, which essentially specifies the dollar amount by which the rate of return on a business exceeds a benchmark rate of return. For example, the worksheet shown in Figure 3-1 shows the net present value equal to \$9,821.71. In other words, this investment exceeds a benchmark rate of return by \$9,821.71. You can’t see it — it’s buried in the formula — but the benchmark rate of return equals 10 percent. So this rate of return essentially is \$9,821.71 better than a 10 percent rate of return.

To calculate the net present value by using Excel, you use another function. In the case of the worksheet shown in Figure 3-1, for example, you click cell G6 and type the following formula:

=NPV(0.1,B3:B22)+B2

This formula looks at the cash flows for years 1 through 20; discounts these cash flows by using a 10 percent rate of return; and then compares these discounted cash flows with the initial investment amount, which is the value stored in cell B2.

All this may sound a bit tricky, but essentially, this is what’s going on: The net present value formula looks at the cash flows stored in the worksheet and calculates the present value amount by which these cash flows exceed a 10 percent rate of return.

The discount rate equals the rate of return that you expect on your capital investments. I should also note that the discount rate is the rate at which you can reinvest any money you get from the capital investment’s cash flows.

One final comment about the information shown in Figure 3-1 (this is also true of the information from Table 3-4): In this figure, I’ve described how to calculate pre-tax cash flows and, therefore, how to calculate a pre-tax rate of return measure. In some situations, however, you may want to calculate an after-tax set of cash flows and an after-tax rate of return. If taxes are a significant factor and if you’re considering alternative capital investments that deliver different tax benefits, you can get more precise and sometimes different results by looking at after-tax cash flows and after-tax rates of return. If you do want to look at after-tax cash flows and profitability measures, you probably need the help of your tax advisor.

Some problems with the IRR measurement

I kind of like the internal rate of return (IRR) measurement because it makes a lot of intuitive sense. Capital budgeting is burdensome enough without being weighed down further by some tricky, abstract, theoretical capital budgeting tool such as the net present value.

You should know, however, that the internal rate of return has some practical weaknesses, which is why people with MBAs and PhDs in business and finance greatly prefer the net present value measure. In this sidebar, I identify these weaknesses for you. Knowing about the weaknesses enables you to more safely use the IRR tool. On the other hand, knowing about the weaknesses may also make you choose to just bear with the abstractness of the net present value model and use it instead. Anyway, here are the weaknesses:

· The IRR measure doesn’t always identify the best investment. In other words, you sometimes can’t pick the investment with the highest IRR and get the most profitable investment. As an extreme example, suppose that you have \$100,000 to invest. Would you rather invest only \$10,000 of your money in something earning 20 percent annually or look at something earning 18 percent annually in which you can invest the entire \$100,000? Do you see the difference? Twenty percent of \$10,000 isn’t going to be as good as 18 percent of \$100,000. Unfortunately, the IRR measure — by focusing on the percentage return — sometimes causes people to lose sight of the dollars of profit, which obviously is what you really want to maximize. By comparison, the net present value does calculate a straight dollar profit amount. By picking an investment with the highest net present value, you’re picking the investment that delivers the most dollars and profits.

· The IRR measure doesn’t recognize reinvestment risk very well. This sounds like another mumble-jumble problem, but it’s actually a pretty important one. Suppose that you have a million dollars to invest. Would you rather pick a 1-year investment (Option A) that earns 30 percent or a 20-year investment (Option B) that earns 20 percent? At first blush, a 30 percent investment seems like a pretty good one. Obviously, 30 percent is a lot more than 20 percent. However, here’s what you have to consider: Where are you going to invest the money from Option A one year from now, when that investment liquidates? The key is that you have to be able to invest the \$1.3 million (which is what you get from Option A one year from now) in something that beats the Option B investment. In other words, you have to think about that reinvestment risk for your investments. The IRR doesn’t really do this. By comparison, the net present value does. Implicitly, the net present value assumes that you can reinvest money at the discount rate used in the calculation. In essence, the discount rate is the going rate that you can earn on your other capital investments, so it automatically factors in reinvestment.

· The IRR measure doesn’t always produce a solution or a unique solution. The IRR formula isn’t solvable, for example, when the cash flows don’t really look like investment cash flows. If you have an investment that generates cash only because there’s no initial cash outlay, you can’t calculate an internal rate of return. But such an investment, obviously, is a very good deal that you should select. A related problem is that sometimes, the IRR formula can’t be uniquely solved. This business about no unique solution stems from a little bit of mathematical weirdness. (The problem is that technically, an IRR formula is an nth root polynomial equation with up to nth possible solutions!) This multiple-solutions weirdness pops up when you have the cash flow signs changing over the years that the investment is held. In the case of the office-building investment, only one sign change exists. In year 2, the cash flow is negative. And in year 3, the cash flow becomes positive and stays positive. This means that the building has one single internal rate of return. If in some years the cash flow was positive and in some years the cash flow was negative, however, each of these flips from negative to positive cash value, or vice versa, indicating another solution to the IRR formula. I won’t go into any more detail, but the important point is that by using the net present value formula, you always know that a solution exists and that it’s the single unique solution, given a particular discount rate.

An important thing to know about pre-tax cash flows and returns versus after-tax cash flows and returns: Make sure that you’re using apples-to-apples comparisons. It’s often fine to work with pre-tax cash flows; just make sure that you’re comparing pre-tax cash flows with other pre-tax cash flows. You don’t want to compare pre-tax returns with after-tax returns. That’s an apples-to-oranges comparison. Predictably, it doesn’t work.

Measuring Liquidity

In large businesses, people don’t worry or talk much about liquidity — at least when it comes to capital investments. Liquidity as a criterion for looking at capital investments is downplayed. The logic behind this is that in most cases, very large firms have almost unlimited access to capital through the capital markets (the stock markets, the debt markets, or even just big-time borrowing from enormous banks). For many smaller businesses, however, liquidity is important. You can make only a limited number of investments. Additionally, you have a limited amount of capital — less than you like, almost always. New opportunities and ways to invest your money continually arrive. For these reasons, you typically want to look at the liquidity of your capital investments.

One easy way to measure liquidity is with a payback period, which measures what it takes for an investment to pay back its original investment. The office-building example doesn’t work very well for this sort of calculation, so to make things a little easier, suppose that you’re considering a \$10,000 investment that produces \$2,000 a year in net cash flows. In this case, you can calculate the payback period with the following formula:

Payback period = initial investment/annual cash flow

In the case of the \$10,000 investment described here, the actual formula is

\$10,000/\$2,000 = 5

This means that the \$10,000 investment, through its \$2,000-per-year cash flows, takes five years to pay back.

Again, you don’t want to focus on liquidity. Liquidity is almost never as important as profitability. But even though profitability is paramount, liquidity is often something that you want to consider. At times, you’re going to want investments that pay back more quickly rather than those that pay back less quickly. When the investments do pay off, you’ll have other good reinvestment opportunities.

Obviously, risk matters. Risk is an issue even with simple investments like bank CDs. But with capital investments, no government agency is looking out for your interest and picking up the pieces if things do a Humpty Dumpty and come crashing down.

So think for a minute about risk management and assessment in the case of capital expenditures. Here are three important comments that I can share:

· Be very careful and thoughtful in coming up with cash flows. The better job that you do of thinking about and estimating the cash flows from a capital expenditure, the more reliable and useful your results are. Good cash flow estimates produce good rate of return measurements.Look back to the examples shown in Tables 3-1, 3-2, 3-3, and 3-4 earlier in this chapter.

· Experiment. You absolutely need to experiment with your assumptions. Make changes, and see how those changes affect both the cash flow and rate-of-return measurements. Looking back at the cash flow information shown earlier in Tables 3-3 and 3-4, for example, you can see that the single biggest cash flow in the building investment is the resale amount in year 20. It would be very interesting to see what effect a lower inflation, or appreciation, rate has on the ultimate rate of return. A 2 percent inflation rate would dramatically change the cash flows and the rate of return measurement for this investment. Similarly, an inflation rate of 5 percent or 6 percent over those 20 years would dramatically change things. In the former case, things get ugly, quickly. In the latter case, well, we all remember how good a leveraged real estate investment can be when given high, continued inflation rates, right?

· Think about the discount rate that you use. I don’t spend a lot of time talking about the discount rate, but you should implicitly take into consideration the risk that an investment makes you face. My finance professor always said, “Your discount rate should equal the rate of return that similarly risky investments produce.” There’s tremendous wisdom in this simple guideline. (Thanks, Professor Schall!) In other words, if you’re looking at a very risky investment, you should compare that investment with the hoped-for higher rates of return that other, similarly risky investments deliver. You’d never pick an investment that, given its risk level, delivers an inferior rate of return. At the same time, if you’re looking at lower-risk investments, you want to use a lower discount rate. A relatively low-risk investment in something like an office building, for example, shouldn’t be evaluated with a discount rate that may be appropriate for some super-risky investment in some new bit of leading-edge technology.

You want to try some different discount rates. By experimenting not only with your cash flow numbers, but also with your discount rates, you can see how the quality of an investment changes when you use different discount rates (and implicitly make different assumptions about the investment’s risk).

What Does All This Have to Do with QuickBooks?

So here’s a question: What does all this capital budgeting stuff have to do with QuickBooks?

Well, quite honestly, capital budgeting really doesn’t relate directly to using QuickBooks. In some ways, capital budgeting is about a financial management task that’s critically important and that you need to think about … but it’s a task that QuickBooks doesn’t directly support.

That said, do note that much of the data that you’ve collected with QuickBooks is often extremely useful for getting good estimates of the savings and costs associated with some capital expenditure.

In looking at the example of investing in an office building, for example, knowing what you’ve been paying in rent and what you may be able to save by buying your own building is exactly the sort of information that you need — and exactly the sort of information that the rich financial database of QuickBooks supplies.

In truth, your estimates of cash flows typically are much more involved than what I show in this chapter. If you do have a building investment under consideration, you should consider all sorts of expenses related to repairing and maintaining the building. If you’ve been leasing space in someone else’s building, you have to consider all sorts of expenses associated with that, including special insurance that the landlord makes you buy, special amounts that you spend because the space doesn’t quite meet your requirements, and so on. QuickBooks helps you with this type of information.

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