From the course: Finance Foundations
Example: Buying a car in Hong Kong
Let's walk through an actual example of a capital budgeting decision. This is a real example that my wife, Ramona, and I went through when we moved to Hong Kong. Should we buy a car? The cost of the car we were considering was HK$40,000. Now, HK$8 is roughly equivalent to one U.S. dollars, so that's about 5,000 U.S. dollars. So we're not talking about a great car, just a weekend car so we can save on subway and bus fares for my wife and I and our children. We figured that our annual savings would be about HK$10,000. We estimated the useful life of the car to be about five years. And for our family cost of capital, we use 10 percent. So the capital budgeting decision is this, should the Stice family buy this car? Well, the first thing we did was compute the payback period. If we spend HK$40,000 to buy this car, and we'll save $10,000 per year, we will recover our investment cost in four years. This is called the payback period. All right. Now let's do some present value calculations to evaluate the Hong Kong car. The car cost HK$40,000 right now. The savings will be $10,000 each year for the next five years. If the interest rate is 10 percent, the present value of saving $10,000 each year for five years is $37,908. This number can be computed using a business calculator or an Excel Spreadsheet. Well, computationally, this is a pretty easy decision to make. The cost of the car is $40,000. If we buy the car, we're going to receive savings that have a value now of $37,908. In other words, we're paying $40,000 to save $37,908. Add these two numbers together and you get -$2,092. The label for this number is the Net Present Value, or NPV, of the car. The NPV of the car is -$2,092. The instant that we decide to buy the car, we lose $2,092 in present value terms. So should we buy the car? The car has a negative net present value. The worst thing you can say about something in a finance context is that it is a negative net present value project. For example, if you come up to me and you want to compliment me, you should say this, "Oh, I was talking with your son the other day and he seems like a positive net present value project." That's the nicest thing you could say to me. The numbers say we should not buy the car, but the numbers are just the start of the analysis. Now we have to use our judgment. We consider the numbers along with the other non-financial benefits. In this case, because of the numbers, my wife Ramona, and I decided not to buy the car. And I think as I think about it all these years later, that we made a mistake. We didn't properly weigh the non-financial benefits in terms of transportation flexibility to visit the many beautiful places out in the mountains and beaches of Hong Kong. We made the decision based on the numbers, when we probably should have used a little bit more judgment and have considered the non-financial benefits of having a car. So remember, when making a capital budgeting decision, or any other decision for that matter, the numbers are just the start of the decision-making process. Once you've done the numbers, then consider the other non-financial factors.
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