What is 'Betterment'
Betterment is an expenditure that improves an asset's performance or increases its value. General repair or maintenance to sustain an asset's current value is not considered betterment, and those costs are expensed as they are incurred each month or year. As an example, adding an automatic garage-door opener to the garage is considered betterment, because the new door adds value to the home.
BREAKING DOWN 'Betterment'
In business, replacing an outdated piece of equipment with a new asset that increases a manufacturing facility's production capacity is considered betterment, because the new asset's value is greater than its value of the old equipment.
Accountants capitalize any spending that extends the useful life of an asset or increases an asset’s value, which means the dollar amount is added to the asset account balance. Because the attachment makes the machine more valuable, the spending is not immediately expensed. If an expensive attachment is added to a machine, for example, the accounting department increases a machine asset account and reduces cash for the cost of the attachment. The cost of the attachment and the machine are both expensed as the asset depreciates over its useful life.
Factoring in Capital Budgeting
Every company must invest in assets to operate the business and grow sales over the long term, and capital budgeting is the process of planning for future investments. The business must ensure there are sufficient cash inflows to either purchase the asset for cash or finance principal and interest payments on a loan. Many firms use net present value (NPV) to make decisions about the profitability of a large asset purchase by evaluating the cash inflows and outflows related to the purchase.
Examples of Net Present Value
NPV applies a discount rate to the cash inflows and outflows, which is typically a minimum rate of return the business requires on any investment. Assume, for example, XYZ Manufacturing has an 8% discount rate and the company is considering the purchase of a $100,000 machine. The company pays cash for the machine, and the firm expects the machine to generate $20,000 in additional cash inflows for seven years. Each of the $20,000 cash inflows is adjusted to present value using a discount rate of 8%. If the sum of the cash inflows is greater than the $100,000 cash outflow to buy the asset, the company should make the purchase. If the firm financed the purchase, the cash outflows for principal and interest payments are also adjusted to present value and included in the NPV calculation.