What is a lease? Why would you choose to lease instead of buy a capital item? What steps would you follow to decide whether to lease or buy a computer system?
A lease is a contract that stipulates conditions of rent of a certain property by a renter from a property owner/lessor. Under a lease agreement the renter guarantees the lessor to pay a certain amount of money usually over a specific period of time. In order to decide whether to buy or to lease a computer system it is necessary to estimate the amount of time that the system will be used and to compare the leasing costs over this time with the purchase price of the system. If the former is less than the latter, it is more reasonable to lease the system. This analysis should also consider other variables, such as tax benefits, present value of the money and the amount of depreciation. Although in the long-run leasing may be more expensive than buying and it gives the renter only a limited control over the acquired capital item, leasing also offers a number of benefits. Thus, leasing requires lower initial investment, allows more flexibility to change or upgrade equipment and makes it easy for small businesses and start-ups to acquire expensive capital items and thus to remain competitive in the market.
What is meant by capital planning? Why is IRR important to an organization? Why is NPV important to a project? How would you select from multiple projects presented to your organization?
Capital Planning is a budgeting process that is necessary to plan resources for long-term development of an organization. In the business environment capital planning usually deals with investments into new machinery and equipment, into research and development and other capital expenditures that are important for the organization. Capital Planning usually uses IRR or NPV methods to assess cash flows from a specific investment. NPV is the difference between the values of cash inflows and cash outflows that have been discounted in order to reflect the time-value of money. This indicator shows how much value the project adds for the company. If NPV is positive, than the project generates cash flows and should be undertaken. Projects with negative NPVs should be rejected as they destroy value for the company. IRR (Internal Rate of Return) is a discount rate that yield NPV equal to 0. The rate is compared to the cost of capital, and if IRR is greater, then the project should be undertaken. Both NPV and IRR are commonly used to select among mutually exclusive projects. In general, projects with high NPV and IRR should be preferred. However, this is only true if the amount of investment is comparable.
Weekly Summary - In your own words, provide a summary of the main points of this week.
This week was dedicated to capital planning and its use in the daily decision-making of organizations. As company resources are always limited, it is necessary to estimate the value that different projects add to the firm and to select only those initiatives that generate the most value. This logic applies both to project selection and to the decision to acquire capital items, which can be done either through a purchase or through a leasing contract. Capital budgeting techniques help managers to make the right decision and to evaluate the value that each option brings to the company. Specifically, IRR and NPV techniques are often used in financial analysis in order to estimate the benefit that every project brings. Negative NPV or IRR below the borrowing rate strongly signal that the project is likely to destroy rather than to create value. It is important to remember, however, that it is not possible to rely only on capital budgeting in making decisions. Some initiatives have strategic importance for the company even despite their low profitability, therefore rejecting them solely based on the NPV or the IRR analysis could potentially harm the business in the long-run.
