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Tools for Evaluating Capital Investment

Definition: The term Capital Investment has two usages in business. Firstly, Capital Investment refers to money used by a business to purchase fixed assets, such as land, machinery, or buildings. Secondly, Capital Investment refers to money invested in a business with the understanding that the money will be used to purchase fixed assets, rather than used to cover the business' day-to-day operating expenses.

Invested capital represents the total cash investment that shareholders and debtholders have made in a company. There are two different but completely equivalent methods for calculating invested capital. The operating approach is calculated as: Invested capital = operating net working capital + net property, plant & equipment + capitalized operating leases + other operating assets + operating intangibles other operating liabilities cumulative adjustment for amortization of R&D

Businesses often face the need to spend large amounts of money on assets that will be functional for many years. Here are a few examples: Equipment to improve an unsafe work situation or to protect the environment Equipment to test the consistency of products as required by the customer Equipment to package, label, and ship products according to the customers specifications Equipment to reduce labor costs and improve the quality of products Purchase of a building instead of leasing space

Limitations such as time, money, and logistics frequently prevent a company from moving forward with too many major expenditure projects at the same time. Instead, a company will often rank its projects by priority and profitability. By using a process called capital budgeting, the company decides which capital expenditure projects will be undertaken and when. At the top of the list of capital expenditure projects are those for which no real choice exists (e.g., installing an updated sewer line within the plant to replace one that is leaking, correcting a safety hazard, correcting a code violation, etc). The remaining capital expenditures are usually ranked according to their profitability using a capital budgeting model.

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Net Present Value (NPV) Internal Rate of Return (IRR) Payback Period Average Rate of Return (ARR) Profitability index

NPV method calculates the expected monetary gain or loss from a project by discounting all expected future cash inflows and outflows to the present point in time, using the Required Rate of Return Based on financial factors alone, only projects with a zero or positive NPV are acceptable

The IRR Method calculates the discount rate at which the present value of expected cash inflows from a project equals the present value of its expected cash outflows A project is accepted only if the IRR equals or exceeds the IRR

Internal rate of return (IRR)

D1 + (pvD1-pv cash flow) * (D2-D1) (pvD1-pvD2)

Payback measures the time within which the intial investment of the project would or can be recovered. Shorter payback period are preferable Organizations choose a project payback period. The greater the risk, the shorter the payback period Easy to understand

 With uniform cash flows:

Payback Period

Net Initial Investment annual cash inflow

With non-uniform cash flows: add cash flows period-by-period until the initial investment is recovered; count the number of periods included for payback period

Example: Payback Period

two investments to consider: (1) rs.9000 investment, generates rs.4500 each year (2) rs.18000 investment, generates rs.6000 each year which one would you choose, using payback period?

Profitability index method measures the present value of benefits for every dollar investment. In other words, it involves the ratio that is created by comparing the ratio of the present value of future cash flows from a project to the initial investment in the project.
Profitability index = Present value of cash inflow Present value of cash outflow

AVERAGE RATE OF RETURN

This method is also called Accounting Rate of Return Method. This method is based on accounting information rather than cash flows. There are various ways of calculating Average Rate of Return
average Rate of Return average net profit after tax

original or average investment

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