Benefit-Cost Ratio Analysis for Equipment Purchasing

Benefit/Cost Ratio

The benefit/cost ratio analysis is a financial metric used to estimate the total value of money for a given project or acquisition (Burton & Jermakowicz, 2015). It is analyzed relative to the total cost of a business venture. In other words, it takes into account the amount of monetary gain associated with an investment, vis-à-vis its implementation costs. Since these two variables are evaluated when assessing the value of an investment, the benefit-cost ratio is typically expressed in discounted present values (Burton & Jermakowicz, 2015).

Average Payback Period

The average payback period refers to the time an investor is expected to get their money back (Herz, 2016). In other words, it highlights the period which it will take to repay initial investments. For example, if a project worth $400,000 gives an annual return of $100,000, the average payback period will be four years. As explained from the above example, this financial index is typically expressed in years or in a fraction of years (Herz, 2016).

Return on Investment

The return on investment is a ratio that compares the net profit and cost of undertaking a project (Needles, Powers, & Crosson, 2013). It is used to evaluate whether a business venture would make profits or incur losses and by how much. A high return on investment implies that an investor is making good returns from a business venture, while a low ROI implies poor returns on the same (Needles et al., 2013).

Importance of Understanding Terms When Purchasing New Equipment

The above financial terms are important when purchasing new equipment because they help to determine which investments to make and which ones to avoid (Burton & Jermakowicz, 2015). They also help to identify trends in the performance of a business venture (relative to financial flows) and compare it with those of other enterprises in the industry (Nobes, 2014). Therefore, it is typically used in decision-making processes and could provide an insight into whether buying a piece of equipment makes financial sense, or not.

Case Study of Business Opportunity

Yes, I would pursue the business opportunity because a benefit-cost/ratio analysis of the equipment’s returns and costs is positive. This view is supported by the net present value of the investment which is $2,522,055. The benefit-cost/ratio is also positive at 1.51. In this regard, the business opportunity should be pursued because from a capital input of $4,950,000 the venture will yield gross returns of $7,472,055. The net gains that would be made from the investment are realized from the difference between the two numbers, which is $2,522,055. This figure is indicated in the calculations as the net present value.

Another reason why the business opportunity should be pursued is because the total cash inflow that would result from the purchase is almost double the amount of money invested ($9,395,000). This fact means that the total amount of money injected in the business will be recouped and the balance used to pay for operating expenses, such as maintenance, installation, and wages.

Part of the reason why the business opportunity would make sense is the fact that increased efficiency that would be realized from the purchase would also result in labor savings because there will be a reduction of 10 full-time employees who would otherwise be drawing salaries or wages from the venture. Therefore, the business opportunity should be pursued because the total expense increase ($40,000) is lesser than the expense decreases, which is pegged at $1,560,000. The average payback period, which is 2.6 years, is also a relatively short time to recoup all the money back. Therefore, it adds to the value of the investment. Based on these findings, it would make sense to pursue the business opportunity.

References

Burton, G., & Jermakowicz, E. (2015). International financial reporting standards: A framework-based perspective. London, UK: Routledge.

Herz, R. (2016). More accounting changes: Financial reporting through the age of crisis and globalization. London, UK: Emerald Group Publishing.

Needles, B., Powers, M., & Crosson, S. (2013). Principles of accounting (12th ed.). London, UK: Cengage Learning.

Nobes, C. (2014). International classification of financial reporting (3rd ed.). London, UK: Routledge.