Applications of Capital Budgeting to Supply Chain Situations

Applications of Capital Budgeting to Supply Chain Situations

 

These scenarios describe how managers would evaluate mutually exclusive and independent capital investment projects.

 

  • ·        Lease or Buying of Capital Equipment – Companies can use NPV to see the difference between buying equipment or leasing equipment.  Leasing allows for a firm to get a cheaper payment for equipment at the time and replace equipment more often.

 

  • ·        To Automate or not to Automate – In this scenario, a firm would have to cost out the savings of automation versus not to automate to get to the cash flows, then we could look at the series of cash flows versus the initial investment to see if the NPV is positive or negative.

 

  • ·        Prioritizing Independent Projects (The Profitability Index, or PI) – Some investment decisions involve choosing among independent projects, where accepting one project does not necessarily preclude accepting another unrelated project.  However, managers typically have limited funds to invest and therefore must prioritize their investment resources (capital rationing).  To prioritize independent projects, we cannot simply compare the NPVs, which are stated as absolute dollar values.  This makes comparing projects of different sizes difficult.  Although the IRR is a relative measure of performance, it assumes that the cash flows will be reinvested to earn the same IRR, which is unlikely to be true for independent projects.  Managers should prioritize capital investment projects based on a factor call the profitability index.  The profitability index is calculated as follows: PI = Present value of future cash flows/ Initial Investment.  A PI>1 means that project has a positive NPV because the future cash flows (numerator) is higher than the denominator (initial investment).  A PI<1 that the NPV is negative.  One prioritizes projects by the highest order PIs.

 

The PI is conceptually the same as the method used to prioritize constrained or bottleneck resources.  The PI measures the amount of long-term value that is generated per unit of the scarce resource.