Capital Investment Decisions

Capital Investment Decisions

Capital investment decisions are long range decisions involving opportunities to invest in new assets or projects. They are among the most important decisions made by managers. Large amounts of resources are placed at risk for long periods of time, and they affect the future development of the firm. The decision making process for capital decisions is called capital budgeting.

Capital Budgeting

There are two types of capital budgeting. The first is independent projects, also called mutually exclusive projects. If accepted or rejected, they do not affect the cash flows of other projects. The second is competing projects. Acceptance of one alternative precludes the acceptance of another.

Managers must decide whether or not a capital investment will earn back its original outlay, and provide a reasonable return. A reasonable return will be an amount to cover the opportunity cost of the funds invested. To make a capital investment decision, managers must make estimates of the quantity and timing of the after-tax cash flows, assess the risk of the investment, and consider the impact of the project on the firm's profits.

Managers must set goals and priorities for the capital investments. They must also establish basic criteria for acceptance or rejection of proposed investments. There are two types of methods for making these decisions, and most companies use both types of methods.

The first is nondiscounting models. These do not consider time value of money. There are two methods within this model: payback period and accounting rate of return (APR). The second is discounting models. these use time value of money. there are two methods within this model: net present value (NPV) and internal rate of return (IRR).

Payback Period

Payback period is the time required for a firm to recover its original investment. If the investment generates even cash flows, then the formula is:

Payback period = Original investment / Annual cash flow

If the investment generates uneven cash flows, then the formula is to add cash flows until the original investment is recovered.

When analyzing payback periods, managers should set a maximum payback period. Any project that exceeds this level should be rejected. Payback periods can be used as a rough measure of risk. The longer it takes for a project to pay for itself, the riskier it is. Firms with riskier cash flows could require shorter payback periods than normal. Firms with liquidity problems need quicker paybacks. When choosing among the alternatives, the project with the shortest payback period is preferred.

The payback method provides information that can be used to help control the risks associated with the uncertainty of future cash flows. It minimizes the impact of an investment on a firm's liquidity. The payback method controls the risk of obsolescence and controls the effect of the investment on a performance measure.

Accounting Rate of Return

Accounting rate of return measures the return on a project in terms of income as opposed to using cash flow. The formula is:

ARR = Average income / Initial investment

Average income is not the same as cash flows. The formula for average income is to add net income for each year of the project and divide by the number of years.

Net Present Value

Net present value is the difference between the present value of the cash inflows and outflows associated with a project. NPV measures the net cash flows of the project. The size of the positive NPV measures the increase in value of the firm resulting from an investment. To use NPV method, a required rate of return must be defined, with a minimum acceptable rate of return.

If NPV is positive, the rate of return on the investment is greater than the required rate of return. The investment, minimum rate of return, and a return in excess of profit are all recovered. The investment is acceptable.

If NPV is zero, then the rate of return on the investment is exactly the required rate of return. the investment and the minimum rate of return are recovered. The decision maker will be ambivalent regarding acceptance or rejection.

If NPV is negative, then the rate of return on the investment is less than the required rate of return. Investment cost may or may not be recovered, and the minimum rate of return is not recovered. Initial investment should be rejected.

Internal Rate of Return

Internal rate of return is the interest rate that sets the project's NPV to zero. This can be found through a complex formula, using trial and error, or using PV tables.

If IRR is greater than the required rate of return, then the project is deemed as acceptable. If IRR is less than the required rate of return, then the project is rejected.

Post Audit of Capital Projects

Post audit of capital projects is the follow-up analysis of a project once it is implemented. It should be completed by an independent party, often internal audit staff. It compares the actual benefits to estimated benefits, and actual operating costs to estimated costs. After the evaluation of the overall outcome of the investment, any corrective action (if needed) is proposed.

There are many benefits of a postaudit. By evaluating the profitability and cash flows, firms ensure that assets are used wisely. Managers are held accountable for results of capital investment decisions. They are more likely to make decisions in the best interest of the firm. Feedback is gained and used in future decision making.

Just as there are benefits of a postaudit, there are also drawbacks. First is that it's costly. Resources have to be dedicated to performing the postaudit. There are limitations of a postaudit. Assumption that drive the original analysis may often be invalidated by changes in the actual operating environment. Also, the accountability must be qualified by the impossibility of foreseeing every possible eventuality.

Mutually Exclusive Projects

Net Present Value and Internal Rate of Return can produce different results. NPV assumes that each cash flow received is reinvested at the required rate of return. It measures cash flow profitability in absolute terms. IRR assumes that each cash flow is reinvested at the computed IRR. It measures cash flow profitability in relative terms. NPV consistently selects the project that maximizes the firm's wealth.

When selecting the best project, there are three steps. The first is to assess the flow pattern for each project. The second is to compute the net present value for each project. Finally, identify the project with the greatest NPV.