Introduction to Capital Investment Analysis

What Is Capital Investment Analysis?

Capital investment analysis is a budgeting procedure that companies and government agencies use to assess the potential profitability of a long-term investment. Capital investment analysis assesses long-term investments, which might include fixed assets such as equipment, machinery, or real estate. The goal of this process is to identify the option that can yield the highest return on invested capital. Businesses may use various techniques to perform capital investment analysis, which involve calculating the expected value of future cash flows from the project, the cost of financing, and the risk-return of the project.

Understanding Capital Investment Analysis

Capital investments are risky because they involve significant, up-front expenditures on assets intended for many years of service, and that will take a long time to pay for themselves. One of the basic requirements of a firm evaluating a capital project is an investment return greater than the hurdle rate, or required rate of return, for shareholders of the firm.

Net Present Value

One of the most common metrics for capital investment analysis is the net present value (NPV) model, which determines how much the expected revenue from a project–called future cash flows–are worth in today's dollars. Net present value shows whether the future cash flows or revenue are enough to cover the initial investment of the project and any other cash outflows.

The NPV calculation discounts–or reduces–the expected future cash flows by a specific rate to arrive at their value in today's terms. After subtracting the initial investment cost from the present value of the expected cash flows, a project manager can determine whether the project is worth pursuing. If the NPV is a positive number, it means it's worth pursuing while a negative NPV means the future cash flows aren't generating enough return to be worth it and cover the initial investment.

Essentially, net present value (NPV) measures the difference between the present value of the project's cash inflows and the present value of any costs or cash outflows. For example, a company might compare the returns from a project to the cost of financing that project. The cost of financing would be the hurdle rate used to calculate the present value of the cash flows. A project wouldn't be worth pursuing if the expected cash flows aren't enough to cover the hurdle rate and the initial investment cost.

Discounted Cash Flow (DCF)

Discounted cash flow (DCF) is similar to net present value but also slightly different. NPV calculates the present value of cash flows and subtracts the initial investment. DCF analysis is essentially a component of the NPV calculation since it's the process of using a discount rate or an alternative rate of return to measure whether the future cash flows make the investment worth it or not.

DCF is popular with investments that are expected to generate a set rate of return each year in the future. It doesn't take into account any start-up costs but merely measures whether the rate of return on the expected future cash flows is worth investing in based on the discount rate used in the formula.

With DCF analysis, the discount rate is typically the rate of return that's considered risk-free and represents the alternative investment of the project. For example, a U.S. Treasury bond is typically considered risk-free since Treasuries are backed by the U.S. government. If a Treasury paid 2% interest, the project would need to earn more than 2%–or the discount rate–to be worth the risk.

The present value is the value of the expected cash flows in today's dollars by discounting or subtracting the discount rate. If the result or present value of the cash flows is greater than the rate of return from the discount rate, the investment is worth pursuing.

Special Considerations

Capital investment decisions are not made lightly. Analytical models are easy to set up. The inputs, however, drive model results; therefore, reasonable assumptions are critical for determining whether a contemplated investment goes forward. Cash flows beyond, say, three or five years can be difficult to project. The discount rate, when applied to years far into the future, has a substantial impact on the present value calculation.

Sensitivity analysis, whereby varying inputs are plugged into the model to gauge changes in value, should be performed. But even then, unexpected events can upset the best-designed model with the most reasonable assumptions, in which case the modeler may decide to integrate contingency factors into the analysis.