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What are the Best Analytical Tools to Evaluate Capital Investment Decisions?

October 24, 2022

Wondering whether you should invest in hiring new team members, or new equipment or a new customer relationship management system? Here’s what to do when there are multiple projects competing for management’s limited budget.

Businesses don’t have unlimited funds to pursue growth opportunities. Each year, management must make tough choices between capital investment projects, often pitting one department against another. Relying on analytical tools — rather than just gut instinct — can help you decide what’s right for your situation.

For example, your sales department might want to spend $250,000 to hire new team members, your plant manager might ask you to purchase $300,000 of new equipment, your product team might want to acquire $50,000 in intellectual property from a competitor and your marketing team might ask you to invest $100,000 in a customer relationship management (CRM) system. All of these projects are competing for management’s limited budget. Which ones should be pursued immediately — and what belongs on the wish list for next year?

Forecasting Cash Flows

When evaluating capital investments, each project’s net cash flow must be forecasted over the next three to seven years. When generating these forecasts, management should use market-based assumptions, such as government publications, industry outlooks and comparable transactions, whenever possible.

Even when you’re able to rely on objective data sources, forecasting cash flows and comparing divergent projects isn’t always straightforward. Some projects will generate positive cash flow in a year or two, but others may take longer to pay back the amount invested. In general, projects with longer payback periods are perceived as riskier investments (and vice versa).

It’s important to look beyond just top-line growth. A comprehensive cash flow forecast will evaluate each project’s annual:

  • Expected contribution to revenue or cost savings,
  • Incremental expenses (net of tax savings), and
  • Incremental working capital and fixed asset needs (net of tax breaks from first-year bonus depreciation or Section 179 deductions).

You also must evaluate how each project will affect the balance sheet. This analysis tells how much cash a project will need each period and whether internal resources will be sufficient to finance the project. Some endeavors will require the company to draw from its line of credit; others will necessitate additional loans or capital contributions. Projects that invest in tangible assets (such as equipment or real estate) that can be pledged as collateral may be perceived as less risky than investments in intangible assets (such as patents or human capital).

Factoring in the Time Value of Money

Once you’ve forecasted expected cash flows, the next step is to factor in the time value of money. Essentially, this concept means that a dollar in your pocket today is worth more than a dollar you expect to receive tomorrow. There’s generally an opportunity cost for tying up money that could be otherwise spent on other worthwhile strategic growth opportunities.

One tool management can use to assess capital investment alternatives from various departments with different levels of risk and payback periods is net present value (NPV). This technique discounts each year’s expected cash flow into its present value. A project’s NPV is the sum of the present values for all the years in the forecast period.

What’s the appropriate discount rate to use when computing NPV? Management often uses the company’s cost of capital. But higher risk options (such as pursuing a venture outside the company’s core competencies or in an unfamiliar foreign country) may warrant a higher discount rate.

Projects that generate negative NPV may not be worthwhile from a financial point-of-view. When evaluating competing projects, the projects with the highest NPV are generally prioritized. However, qualitative factors (such as sustainability goals or the owner’s personal preferences) may also factor into the decision.

Another powerful financial tool is internal rate of return (IRR). This is the rate at which a project’s NPV is zero. The underlying logic is simple: If a project’s IRR exceeds the company’s cost of capital (or another predetermined “hurdle rate”), it’s generally worth pursuing from a financial perspective. Again, when multiple projects are being evaluated, priority is generally given to those that generate the highest IRR.

We Can Help

Our CFO Services team can help you develop a disciplined approach to evaluating growth opportunities, which can dramatically enhance interdepartmental buy-in. We have experience forecasting and discounting expected cash flows from various capital investment alternatives, while taking accounting and tax issues into consideration. Contact us for more information.

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