Capital investment analysis is generally referred to as analysis of investment alternatives. Capital investment analysis is tightly connected with capital investment decisions that contain the purchase of different items for business, such as machinery, equipment, land, buildings, etc. These decisions are the most important that can be undertaken by the manager, as they often involve large amount of money and will influence business activity during several future years. Even though that influence can be positive and increase business profit, this would occur in future, and the investments are to be made immediately.
Business manager cannot foresee the future, however they have the opportunity to estimate all investment alternatives the best they can. Gathering data and information – is the most essential thing in capital investment analysis.
Selection of the investments that are supposed to improve the financial performance of business contain two tasks: analysis of economic profitability and financial feasibility. Economic profitability will reveal whether the investment alternative is economically profitable. But being economically profitable, the investments may not be financially feasible, or in other words, there may not be sufficient cash flow to make necessary interest and principal payments. Therefore, business manager should fulfill both analyses before making the final decision of accepting or rejecting particular investment alternative.
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The main task of economic profitability analysis is to determine whether investment will make the contribution to the long-term business profits. Net present value or discounted cash flow is said to be the most relevant and commonly accepted technique. The basic idea of net present of money procedure is that money we have now are worth more than money we will receive in future. A dollar that we have today, we can invest and generate profit; therefore it is worth more than a dollar that we will have tomorrow. The longer we should wait to get money, the more heavily they should be discounted. The procedure of discounting converts the cash flow that happen during some period in future into single current value, so that the future value be compared to their present value.
Understanding of the idea of time value of many will be very helpful in determination of net present value. Net present value (NPV) is calculated for particular investment as the sum of the annual cash flows that are discounted for any respite of getting them excluding placement of funds. Mathematically the equation looks in the following manner:
Where N is net present value, n- time period, K- last period the inflow is expected, ∑- summation of all periods, In- net cash flow during n-period, d- discount rate and O- cash outlay.
Six main steps are required to complete the procedure of net present value analysis:
- Selection of the adequate discount rate that would reflect the time money value.
- Calculation of the present value of cash outlay that is necessary to purchase particular asset.
- Calculation of the benefits, as well as annual cash flow for every year from the investment during the period of its useful life.
- Calculation of the present value of annual net cash flows.
- Actual computation of net present value.
- The decision making process to accept or reject the investment.
When the business manager has the profitability analyzed and has pick up several alternative investments, he has to evaluate financial feasibility of those. Analysis of financial feasibility reveals whether the investment will generate enough cash to be able to pay interest and principal payments on the funds that were borrowed. If equity funds are involved for the purchase of the asset, then this analysis is not necessary.
Determination of the annual cash flows for the particular investment project is the first step in financial feasibility analysis. Those annual cash flows had already been calculated during economic profitability analysis. The second step is determination of annual principal and interest payments on the basis of the loan repayment schedule. Payment schedule is generally before-tax and cash-flows are after-tax, and therefore payment schedules must be adjusted to after-tax basis. This can be easily done by calculating tax savings from interest deductibility and subtracting those savings from the loan repayment schedule. After that, annual net cash flow should be compared to after-tax annual interest and principal payments in order to estimate whether cash surplus or cash deficit will be observed. In case of cash surplus, the investor can sleep well, as there will be enough cash for loan payments and the project can be fairly considered financially feasible and also economically profitable. In case of cash deficit, there obviously will not be enough cash for loan repayments. There are some ways to reduce or eliminate cash deficits, which include the extension of loan terms, increasing the amount of down payments, and also by more strict and careful expenses control. If cash deficit cannot be reduced in any way, another investment source and alternatives should be considered.
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