CAPITAL INVESTMENT ANALYSIS

CAPITAL INVESTMENT ANALYSIS

RELEVANT INFORMATION

The information needed for many
business decisions requiring to choose between several alternatives, goes
beyond the data provided in the financial statements and involves expected or
future revenues and costs. In this analysis of expected numbers, only what
changes is relevant: what does not change is irrelevant. Thus, the name given
to this analysis as differential or incremental. Note that, while variable cost
do naturally vary, some fixed cost can also change in some of these decisions.
Note also that past costs are irrelevant: they called sunk costs.

LEASING OR SELLING EQUIPMENT

When comparing the choice between
leasing or selling currently unused equipment, the additional, incremental or
differential elements of either are studied for

1- revenue,

2- costs, and

3- net gain.

Book value and accumulated
depreciation are omitted as irrelevant, but net tax effects are not.

MAKE OR BUY

When a manufacturer has excess
productive capacity in space, equipment and labor, producing components may be
better than purchasing them. Producing is chosen if the incremental cost is
lower than the purchase price. The incremental cost combines additional direct
materials, direct labor, fixed factory overhead and variable factory overhead.
Non economic factors, such as relations with suppliers, also often come into
consideration.

REPLACING PLANT ASSETS

The differential analysis for
plant asset replacement takes the following into consideration: annual variable
costs of both new and old equipment, the expected life of new equipment, the
cost of new equipment, the proceeds from the sale of old equipment, and any
annual differential in cost.

OPPORTUNITY COST

When a benefit or profit that
could have been obtained, was not, this foregone benefit is referred to as an
opportunity cost. While accounting is concerned with out-of-pocket costs, for
most business decisions, opportunity costs are just as real and, in some cases,
more significant.

DISCONTINUING UNPROFITABLE
SEGMENTS

Products, branches, segments,
departments, and territories that are unprofitable should be considered for
elimination. If eliminating the unprofitable segments has no effect on fixed
costs, the overall net income from operations will improve from the reduction
in variable costs. This depends, however, on whether the remaining products or
segments are competing or complementary. In the later case, revenue may
decrease creating an opportunity cost in excess of the out-of-pocket cost
reduction. Fixed costs can also play a role if alternative uses for the plant
capacity exist. Lastly, layoffs can affect morale.

SELLING OR PROCESSING GOODS
FURTHER

Manufacturing companies often sell
their products at an intermediary stage of production. When differential
analysis is used to determine whether goods should be sold now or processed
further, only costs and revenues from further processing need to be considered.
When more net income can be earned by processing goods further, they should be
produced providing the production capacity exists.

ACCEPTING SPECIAL ORDERS

A company may accept additional
business at a special price. Incremental or differential analysis is used to
determine the differential revenue and costs. Companies not operating at full
capacity usually can benefit from additional business, if fixed costs remain
the same and the fixed cost per unit produced decreases. However, a company
operating at full capacity is likely to see both fixed costs and variable costs
rise.

CAPITAL BUDGETING

Capital investment analysis or
capital budgeting is used by management to plan, evaluate, and control
long-term investment decisions. Capital investment decisions commonly affect
operations for a number of years and require a long-term commitment of funds.
Capital investment decisions are usually based on either

1- payback period,

2- average rate of return,

3- net present value, or

4- internal rate of return.

AVERAGE RATE OF RETURN METHOD

The average rate of return is
calculated by dividing average annual net income by average investment. When
comparing projects, the highest average rate of return is selected, but
consideration for risk is given. The method is commonly used to determine
investment proposals with a short life span, and therefore, it is not essential
to use present values. The advantage of the method is its simplicity, but
ignoring time value of money is a drawback.

PAYBACK PERIOD

The payback period or cash payback
method measures the number of years it will take to recover a capital
investment. It is determined by dividing the original investment by annual net
cash flows, or, if the cash flows are uneven, by adding up cash flows until the
original investment is recovered. Generally, the shorter the payback period the
better. A disadvantage of this method is that it does not take into account
cash flows beyond the payback period since proposals with longer payback
periods may prove to be more profitable in the long-run. The method is used by
firms with liquidity problems or high risk.

DISCOUNTED CASH FLOW METHODS

Net present value and internal
rate of return are both discounted cash flow methods and give recognition to
the time value of money by discounting, that is, taking the present value of
all future cash flows. Both methods require a discount rate or opportunity cost
of capital. This rate is influenced by a number of factors such as presence of
risk, availability of borrowing, relative profitability, minimum desired rate
of return, nature of the business and purpose of capital investments. The
calculation of discounted cash flows can involve the use of factor tables,
exact formulas, financial calculators or computers.

NET PRESENT VALUE

The net present value is the sum
of the discounted future net cash flows minus the initial investment. All
proposals with positive net present value are acceptable. When competing
alternative proposals are compare, the one with the largest net present value
is chosen. An index determined by dividing the total present value of net cash
flows by the initial investment is sometimes used instead when comparing
project with different size of initial investment.

INTERNAL RATE OF RETURN

The internal rate of return, also
called the discount rate, is the rate for which the net present value is zero.
That is, the sum of future net cash flows discounted for time value of money is
just equal to the initial investment for that particular rate. This internal
rate of return is compared to the cost of capital or cutoff rate, and if
higher, the project is accepted. When competing proposal are compared the
project with the highest internal rate of return is chosen. Calculating the
internal rate of return requires either a trial and error method by looking up
in present value tables a present value factor given by dividing the initial
investment by the annual cash flow, or with the use of a financial calculator
or computer.

CAPITAL INVESTMENT ANALYSIS -
PROBLEMS

A number of factors complicate
capital investment analysis. They are inflation, income taxes, incorrect
estimates and the possibility of leasing instead of buying.

CAPITAL RATIONING

Capital rationing means that there
is only enough capital for the projects with the greatest profit potential. The
proposals are initially evaluated to see if they meet minimum cash payback
period or required average rate of return. If they do, they are then further
evaluated by present value techniques. Proposals that have met all financial
criteria are then subjected to nonfinancial analysis.

CAPITAL EXPENDITURES BUDGET

Once capital expenditure proposals
have been approved, a capital expenditure budget is prepared. Procedures for
controlling expenditures should also be established. Capital expenditures
budgets compare actual results with projections.