Pin Me

How and Why Capital Investment Decisions are Made

written by: •edited by: Marjory Pilley•updated: 6/10/2011

Capital investment decisions are made for a number of reasons. Capital equipment suffers wear and tear and must be replaced, or new technology must be introduced. If the business is expanding, new buildings and equipment will be needed. Make sure you consider all of the factors in this decision.

  • slide 1 of 5

    Why Capital Investment is Needed

    Capital Investment Capital investment is required at regular intervals during the life of a business enterprise. As older machinery and equipment wears out, it must be replaced by newer models that incorporate the latest technology to enable the business to keep up with its competitors. The enterprise may be the first in its industry to introduce certain cutting edge technology and forge ahead of its competitors by making a capital investment decision at the right time.

    Capital investment may be aimed at increasing earnings by producing higher quality and technically advanced goods. Other types of investment may aim to reduce the costs of production by manufacturing more quickly and efficiently. Pressure from competitors means that both types of capital investment will be needed regularly. For some enterprises, commencing a new project will involve capital investment that needs to be assessed in terms of the cash outlay needed and the expected future benefits. The factors affecting capital investment decisions include the need for new capital investment, the number of possible alternatives and the computation of expected return on each investment.

  • slide 2 of 5

    Cash Flow Forecasts

    Forecast The future cash flow resulting from the capital investment is one of the major factors affecting capital investment decisions. For each proposed capital investment, the enterprise must put together a cash flow forecast that is as accurate as possible. Often, the capital investment will involve a major cash outflow at the start, followed at a later date by a series of cash inflows as the benefits of the capital investment are realized. These benefits may result from increased earnings into the future, or they may be in the form of cost savings. The cash flow forecast must be as accurate as possible to enable the results of the capital investment to be assessed correctly. The same criteria must be applied to cash flow forecasting for each capital investment under consideration, to ensure that the projects may be meaningfully compared. This enables management to proceed with a realistic assessment of the capital investments available and reach a correct decision on the investment to be made.

  • slide 3 of 5

    Methods Used to Assess Capital Investments

    Various methods are employed to assess potential capital investments and to compare competing investment projects. Some management may use the payback period as a rule of thumb. This looks at the length of time that will pass before the earnings from the capital investment equal the initial outlay. This is a very rough way of assessing a project that does not take into account the time value of money and does not therefore apply any discount rate to the future cash flows.

    Net Present Value Another method for assessing projects is to look at the internal rate of return of the project, which is the discount rate that when applied to the cash flows from the capital investment arrives at a net present value of zero. This discount rate is then compared to a benchmark rate such as the company's cost of capital to arrive at a decision as to whether the capital investment would be worthwhile. This method can give management some confidence that the capital investment will benefit the business but is unreliable for comparing capital investments when the period during which cash flows will continue varies, and where cash flows are irregular.

    A more straightforward method for assessing and comparing capital investments is to consider the net present value of the project. This is determined by discounting the cash flows from the investment at a predetermined discount rate used by the enterprise. This discount rate may be the same as the company's cost of capital. If the net present value of a capital investment is more than zero, the investment is worthwhile for the enterprise. Different proposed capital investments may be compared to one another by comparing the net present value of each project. If the information is presented to management in this way, comparison of the investment projects is easier and an informed management decision may be made.

  • slide 4 of 5

    Taking the Final Investment Decision

    Apart from the numerical analysis of the benefit of capital investments, management must consider the strategy of the company and the needs of the shareholders. A proposed capital investment with a high net present value may relate to a product line that is outside the core business of the enterprise, or to a type of product that is subject to fluctuating demand owing to changes in public taste and fashion. Management may therefore prefer an alternative capital investment even though the cash forecast shows a lower net present value.

    The needs of the shareholders may require the pursuit of capital investments that will pursue growth and increase the value of the enterprise, rather than necessarily increasing cash flow in the short term. The shareholders are the owners of the company and management is responsible to them. If management makes capital investments that are against the wishes of the shareholders they will be held accountable. The shareholders are one of the most important factors affecting capital investment decisions. The final decision must therefore always take shareholder demands into account.

  • slide 5 of 5

    References

    "Typical capital budgeting decisions" on Accounting for Management - see http://www.accountingformanagement.com

    "Capital budgeting" on netMBA - see http://wwww.netmba.com

    Image credits:

    ppdigital on morguefile

    ronnieb on morguefile

    moderncog on morguefile