Capital Investment

November 23, 2010Capital Investmentby EconomyWatch

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A business needs cash to purchase fixed assets, such as land, building, equipment and machinery, as well as to take care ofday-to-day operating expenses. The money invested in a business for the purchase of fixed or large assets is called capitalinvestment.

Capital investment decisions are crucial as their impact on a business is long term. Thus, it is important to evaluate the economic feasibility of the investment.

Points to Consider While Making a Capital Investment

While making a capital investment, one must consider its impact on the profitability of the business in the long term. When estimating profitability, one needs to consider the time value of money. This concept is based on the fact that cash inhand is worth more than cash receivable at a future date. This is because currently-available cash can be invested to generate earnings, while the value of cash to be received in future can decline due to inflation.

A capital investment may result in an increase in revenues. However, revenue growth does not necessarily mean positive returns from the investment, since several factors, such as inflation, interest rates on loans and opportunity cost of money, need to be taken into consideration while calculating the returns.

Determining the Feasibility of a Capital Investment

One can determine the economic feasibility of a capital investment through the following steps:

    1. Discount the cash returns from the investment to reflect the time value of money. This figure would represent the net present value (NPV) of the returns. Adjusting the future flow of income to the present value would help in judgingwhether the returns are at least equal to the cost of the debt and equity funds that need to be committed by your business to purchase the asset.
    2. Calculate the present value of cash required to buy the asset. This value is equal to the purchase price of the asset in most cases. However, this value can be higher in case you wish to build in additional capital to replace or maintain equipment within the facility.
    3. Calculate the annual benefits or net cash flows within the asset’s useful lifetime. The benefits would be the increased net cash flows from the specific investment on an after-tax basis.
    4. Compute the present value of the annual net cash flows. This will give you an estimate of the amount of net cashflows you would be able to generate through the capital investment.
    5. The last computation required is the subtraction of the present value of investment derived in step 2 from the net presentvalue of the investment returns calculated in step.
    4. A capital investment should be approved only if the value in step 5 is positive. A negative figure reflects that the capital investment will result in losses.
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