As we enter the New Year, organizations are preparing to execute their capital spending plans. Ultimately the decision to invest in long-term assets should be carefully examined and supported by cost data and quantitative measurements. Reasons supporting capital spending generally fall into one of the following categories:
- New equipment will provide cost reductions
- Increase capacity through expansion
- Replacement due to age/serviceability of existing equipment
Equipment acquisitions may require evaluating numerous options. Having sound cost data will aid organizations in choosing the best investment.
In evaluating a capital investment, three common calculations are generally utilized:
- Net Present Value (NPV)
- Payback Period
- Rate of Return (ROR)
Each analysis will provide a different viewpoint of the project. Performing all three tests and comparing the results against preset company benchmarks will allow for a more informed decision.
Net Present Value Method:
This method evaluates the present value of the cash inflows and outflows associated with the investment project over the asset’s estimated useful life. The result of the calculation is either a net cash inflow or net cash outflow from the project. The organization should set a target rate of return, or hurdle rate, and use that rate to discount the cash flows.
To illustrate, assume the following scenario:
Company purchases machinery for $1.6M that generates net cash flows of $500,000 for 8 years with no salvage value at the end. Using a hurdle rate of 18%, this project will result in a NPV of $428,000 (using Excel NPV function). In other words, this project will generate $428,000 of net cash in today’s dollars. Generally, projects with a positive NPV would be accepted, projects with a negative NPV would be rejected.
In this example, the project returns greater than 18%, which is evident by the positive net present value. Based on NPV calculations alone, this project would be accepted because it exceeds the hurdle rate.
The payback method is a common computation that determines the length of time it takes for a project to recoup its initial investment out of the cash receipts it generates. The formula for computing the payback period is the Cost of the Investment divided by the Net Annual Cash Flows. When project cash flows fluctuate annually, the computation will require an amortization table style format as the formula will not work.
When evaluating a project based on payback period alone, generally projects with shorter payback periods are preferable to projects with longer payback periods. Organizations should set a target for payback time limit, and measure potential projects against the company’s benchmark.
There are limitations to the payback method. First, the calculation does not consider the profitability of the project since a shorter payback is not an indication of how profitable a project will be over the life of the asset. Additionally, this method does not consider the time value of money. However, understanding how quickly an investment is recovered is an important factor in moving forward with a project.
Rate of Return
The rate of return represents the gain, or loss, on a project, over the life of the project, expressed as a percentage of the investment’s cost. Calculating the rate of return (using the IRR function in Excel) will provide management with the ability to compare projects against each other as well as against the hurdle rate the company has set as a minimum required return.
Focus on Cash Flows
Capital budgeting analysis should focus on cash flows, and not accounting net income. Accounting net income is based on accrual concepts that ignore the timing of cash flows. Cash inflows to be considered would include incremental revenues generated from the asset, reduction in costs and salvage value of equipment at the end of the asset’s useful live. Cash outflows included in the computation would include the initial investment and anticipated repairs and maintenance associated with the asset.
A decision to make a particular investment is dependent on whether the future returns can be justified in terms of the present cost outlay. Since capital outlays lock up resources for many years, it is imperative that a disciplined capital budgeting process exist at any organization.
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