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Three Calculations to Evaluate Capital Spending
October 26, 2023
When executing a capital spending plan, businesses must meticulously scrutinize their long-term asset investments. It is imperative to conduct an extensive analysis of cost data and use precise 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 standard 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 flow.
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.
Payback Period
The payback method is a standard computation that determines the 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 a payback period alone, projects with shorter payback periods are generally preferable to projects with more extended payback periods. Organizations should set a target for a 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 project's profitability since a shorter payback does not indicate 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 allow management to compare projects against each other and 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 include:
- Incremental revenues generated from the asset
- Reduction in costs
- The equipment's salvage value at the end of the asset's practical life
Cash outflows included in the computation would include the initial investment and anticipated repairs and maintenance associated with the asset.
Ultimately, a decision to make a particular investment depends on whether the future returns can be justified in terms of the present cost outlay. Since capital outlays lock up resources for many years, an organization must have a disciplined capital budgeting process.
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