20
CAPITAL INVESTMENT DECISIONS
Introduction and Key Concepts
CHAPTER INTRODUCTION
Capital investment decisions (CIDs) are some of the most important business decisions that managers make. Capital decisions are generally defined as relatively large investments that will have an economic life of several years. We will define capital investments broadly, including purchases of equipment, new product development projects, acquiring a product line or a company, and many others. The capital investment decision is a determination of whether the project is likely to create value for shareholders. In this chapter, we will introduce capital investments, evaluation, and key decision criteria, and outline the steps required to evaluate CIDs. In Chapter 21, we will cover advanced topics of CIDs, including dealing with risk and uncertainty, monitoring projects, and presenting capital investment decisions.
THE CAPITAL INVESTMENT PROCESS
A strong capital investment process is critical to ensure a thorough evaluation and decision. Figure 20.1 outlines key steps in an effective capital investment process.
FIGURE 20.1 Capital Investment Process Overview
Companies should identify potential capital projects as part of their strategic and annual operating planning activities. The capital budget should be an important element of each plan. For strategic plans, the managers should look out three to five years and anticipate significant capital expenditures to support growth, strategic initiatives, and other requirements. Integrating the capital plan into the financial projections will afford the opportunity to review cash flow projections and determine the adequacy of returns over the strategic planning horizon.
For significant expenditures, a capital investment proposal (CIP) should be prepared to document key aspects of the project, including business justification, economic case, alternatives, and implementation plan. The scope of the CIP and the management approval level should scale with the size and importance of the project.
Business Case. The business case should define the strategic and business objectives that will be achieved or supported with this use of capital. In addition to passing certain economic tests, the project must be clearly linked to a strategic or operational objective. Some projects may make economic sense but be outside or even inconsistent with the strategic direction of the company.
Economic Case. All capital investment projects should be supported by financial projections and an economic evaluation. The financial projections should be based on the business case and implementation plan and include the following:
- Estimated costs to purchase and start up the project.
- Incremental revenues, costs, and capital requirements that result from undertaking the project.
- Estimated salvage or terminal value at the end of the project life.
Alternatives. Most projects have several alternative courses of action. These should be explored as part of the capital investment decision and documented in the capital investment proposal. Reviewers should test the basis of selecting the recommended plan to ensure that this alternative provides the best balance of technical, business, and economic performance.
Implementation Plan. Execution and implementation are always critical success factors for any project. Capital projects should be supported with a detailed implementation plan. This plan will provide a road map to achieve the objectives of the capital investment. A good implementation plan is a strong indication that the project is well planned, including identification of resource requirements, risks, and alternatives. The implementation plan also provides a basis for monitoring and reviewing progress of the project. Identifying key assumptions, checkpoints, and go/no‐go decision points will also allow managers to consider redirecting or terminating projects that may be at risk. The characteristics of a good implementation plan are detailed in the sidebar.
Executive Review of Capital Investment Projects
Most companies require management approval for investments over a certain limit. Approval requirements typically escalate to higher levels of management, the board of directors, or even shareholders based on the nature and size of the investment and source of financing. The sidebar (“Executive Review of Capital Projects”) highlights key points that executives should consider in their evaluation of significant investments.
EVALUATING THE ECONOMIC MERITS OF CAPITAL INVESTMENTS
No matter how simple or complex the project, the same basic three steps should be employed to evaluate and select appropriate capital investments. The three steps are:
- Estimate relevant cash flows associated with the project.
- Measure the project's expected performance against investment decision rules.
- Accept or reject based on decision rules.
These three steps focus on the financial or economic part of the evaluation. Of course, there also needs to be a review of other business issues and to ensure the project is consistent with the firm's strategic direction, as described earlier.
Step 1: Estimate Relevant Cash Flows Associated with the Project
Economic evaluations should be based on projected cash flows. The first step will be to estimate the incremental investments and profit and loss (P&L) on the project, and then to estimate cash flows, reflecting the capital investment, depreciation, and working capital requirements.
Estimating both the acquisition or development cost and future cash flows of a project are by far the most important and most difficult part of CIDs. There are three categories of cash flow to consider for most projects: the initial cash outflow or investment, the stream of annual cash flows over the project's expected life, and a residual or terminal value at the end of the project (or projected cash flow).
The definition and application of incremental cash flows is a source of confusion in estimating relevant cash flows. Incremental revenues, investments, costs, and expenses should be limited to those that directly result from undertaking the project. The test is to identify those expenses and revenues that are not incurred if the project is not undertaken.
For significant and complex projects, we should utilize the techniques covered in developing long‐term projections of future business in Chapter 14.
Initial Investment
We need to estimate the total investment or cash outflows associated with the project. This can be as simple as the purchase cost of a new piece of equipment. However, if the machinery is shipped to us and includes freight, installation, setup, and training, then these costs also must be reflected as the total cost of acquiring the asset.
The project investment can become very complex and extend over several years. For example, the total design, approval, and construction of a new refinery or nuclear plant can extend for a decade or longer. Similarly, the development of a new product such as a prescription pharmaceutical can extend over many phases with a high degree of uncertainty of effectivity and approval by regulatory agencies. The investment in these cases may be very difficult to estimate.
All cash outflows must be considered, regardless of the accounting treatment. These include operating expenses (after tax), purchases of property and equipment, development of facilities, and working capital required to support the project.
Cash Flows over Project Life
The second set of cash flows to consider are the estimated annual cash flows over the project's life. For simple projects, such as purchasing a more efficient piece of manufacturing equipment, the savings may be as simple to define as reduced labor or scrap costs. At the other end of the spectrum are complex projects such as new products or the acquisition of a company. In both these cases, a complete set of financial projections would be required, including a complete P&L, balance sheet, cash flow statement, and supporting schedules (see Chapter 14, Long‐Term Projections).
Residual or Terminal Value
We need to estimate what, if any, value may exist at the end of the project's expected (or projected) useful life. For projects involving manufacturing or transportation equipment, the value at the end of life may be trade‐in, salvage, or resale value. For more complex and longer‐term programs such as the acquisition of a business or development of a product line, we must estimate the value of the business at the end of its useful life (or forecast horizon). This value may be a liquidation value if the business would be shut down and the remaining assets sold at liquidation value. If the business could be sold or continue to operate beyond the projected life or forecast horizon, then we need to estimate the terminal or post‐horizon value.
Capital Investment Examples
Case Study 1: Automate Manufacturing Process
Vance Pharmaceutical is considering automating a key part of its manufacturing process. The equipment will cost $100,000 and is expected to reduce manufacturing cycle time, improve yield, and decrease test costs.
What incremental cash flows are likely to result from undertaking this project? This project will probably involve the following incremental cash flow items, among others:
- Cost of equipment
- Installation cost
- Reduced labor and test costs
- Reduced material costs due to yield improvement
- Increased depreciation expense
- Increased taxes on profit improvement
Case Study 2: Develop and Introduce New Treatment
Vance Pharmaceutical is considering the development of a breakthrough treatment for procrastination. The project will require several years of development and will result in a significant increase in sales. The treatment can be produced in the company's existing facilities.
What incremental cash flows are likely to result from undertaking this project? This project will probably involve the following incremental cash flow items, among others:
- R&D investment
- Cost of FDA approval
- Investment in manufacturing process
- Distribution channel and training
- Marketing and promotion
- Revenue and profits
- Working capital required to support program
- Increased depreciation expense
- Increased taxes on profit improvement
Step 2: Measure the Project's Expected Performance against Investment Decision Rules
A variety of measures or decision criteria are used to evaluate the economic characteristics of the investment. In addition to satisfying these economic tests, the project must also be justified on a business and strategic basis. The three most common measures are net present value (NPV), internal rate of return (IRR), and payback. In special situations, additional measures are utilized. Most of the decision rules are based on the economic principle of the time value of money (TVOM). Refer to Chapter 19 to review TVOM, discount rates (DRs), and cost of capital.
We illustrate the measurement criterion with the following simple example:
- Project life: 5 years
- Initial investment: $24,000
- Projected after‐tax savings for 5 years: $8,000
- Project terminates at end of year 5 with no residual value.
- Discount rate: 10%
Net Present Value (NPV)
Net present value (NPV) utilizes the discounted cash flow methodology described in Chapter 19 to account for the time value of money and project risk. The cash flow for each year is discounted back to the equivalent value today (“year 1”) using a discount or hurdle appropriate for the risk level of the project. NPV is the sum of all discounted cash inflows and outflows. A positive NPV indicates that the project has a rate of return that exceeds the discount rate used, and therefore should be approved. A negative NPV indicates that the project has a return under the discount rate, and should not be undertaken.
TABLE 20.1 NPV Illustration 
| Discount Rate (10%) | |||||||
| Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | Year 6 | ||
| Project Cash Flows: | |||||||
| Cash Inflows | −24,000 | 8,000 | 8,000 | 8,000 | 8,000 | 8,000 | |
| Present Value Factor | 0.91 | 0.83 | 0.75 | 0.68 | 0.62 | 0.56 | |
| Present Value | −21,818 | 6,612 | 6,011 | 5,464 | 4,967 | 4,516 | |
| Net Present Value (Sum of PV) | 5,751 | ||||||
In the example in Table 20.1, the NPV is +$5,751, indicating that the project has a return above the expected return (discount rate) and should be implemented. Note that we provided the present value factor (PVF) and present value (PV) for each annual cash flow. This provided insight into the TVOM and the dynamics of the project's NPV.
Internal Rate of Return (IRR)
The internal rate of return (IRR) of a project is the actual rate of return implied in the project's cash flows. If the IRR exceeds the discount rate (DR), the project should be approved. If the IRR is less than the cost of capital, the project should be rejected. Prior to the widespread availability of spreadsheet and finance application software, the IRR would be computed by trial and error by guessing at the IRR and recomputing until NPV = 0.
The project in the example in Table 20.2 has an IRR of 19.9%, which is above the 10% discount rate used for the project. Note that IRR and NPV are consistent decision criteria, using estimated cash flows and the discount rate as key inputs. The use of IRR and NPV will result in consistent decisions as follows:
TABLE 20.2 IRR Illustration
| Internal Rate of Return | ||||||
| Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | Year 6 | |
| Project Cash Flows: | ||||||
| Cash Inflows | −24,000 | 8,000 | 8,000 | 8,000 | 8,000 | 8,000 |
| Present Value Factor | 0.83 | 0.70 | 0.58 | 0.48 | 0.40 | 0.34 |
| Present Value | −20,024 | 5,569 | 4,646 | 3,876 | 3,234 | 2,698 |
| Sum PV | 0 | |||||
| NPV | 0 | |||||
| IRR | 19.9% | |||||
| IRR | NPV | Result |
| IRR > DR | NPV > 0 | Approve |
| IRR < DR | NPV < 0 | Reject |
Payback
The investment payback is a simple measure that estimates how long (in years and fractions of years) it will take to recover the investment in a project. Investments with shorter payback periods are typically viewed as positive; investments with longer payback periods may be rejected or require additional review. This method does not consider the time value of money (that is, cash flow in future years does not have the same value as an equivalent cash amount now). Despite this criticism, it has high acceptance and usage because it is easily understood and measures an important characteristic: How long until we recover our initial investment? Many organizations have rules of thumb based on payback, requiring a certain class of investments to have a payback of three years or less.
In this example, the cumulative cash flow for the project becomes positive in year 3. We estimate the payback as shown in Table 20.3.
TABLE 20.3 Payback Illustration
| Payback | ||||||
| Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | Year 6 | |
| Project Cash Flows: | ||||||
| Cash Inflows | 8,000 | 8,000 | 8,000 | 8,000 | 8,000 | |
| Cash Outflow | −24,000 | |||||
| Cumulative | −24,000 | −16,000 | −8,000 | − | 8,000 | 16,000 |
| Payback | 3.0 | |||||
Typically, the payback will not end exactly at the end of a year and will require as estimation of partial‐year payoffs, using interpolation.
All three methods should be utilized, since they each provide different views into the economic dynamics of the project (see Table 20.4).
TABLE 20.4 Combined Illustration
| Discount Rate (10%) | ||||||
| Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | Year 6 | |
| Project Cash Flows: | ||||||
| Cash Flows | −24,000 | 8,000 | 8,000 | 8,000 | 8,000 | 8,000 |
| Cumulative | −24,000 | −16,000 | −8,000 | − | 8,000 | 16,000 |
| Present Value Factor | 0.91 | 0.83 | 0.75 | 0.68 | 0.62 | 0.56 |
| Present Value Cash Flow | −21,818 | 6,612 | 6,011 | 5,464 | 4,967 | 4,516 |
| Net Present Value | 5,751 | |||||
| IRR | 19.9% | |||||
| Payback | 3.0 | |||||
While NPV indicates whether the project should be undertaken based on a given discount rate, IRR provides the precise rate of return on the project. By comparing the IRR to the DR, you can get a sense of the return “slack.” Payback complements these measures by estimating the number of years until cash outlays are fully recovered. For example, a project may have a positive NPV and a high rate of return, but the bulk of the cash may be recovered late in the project life, or even in the terminal or salvage value. This long payback should be evaluated in the context of project risks.
We used a discount rate of 10% in the example. The discount rate for each project should be based on the level of risk associated with the project. For practical reasons, companies often set a hurdle rate above the company's cost of capital (covered in Chapter 19) to ensure that projects will earn an acceptable return. If individual projects are perceived as having very low or high risk, the discount rate may be adjusted accordingly, as discussed in Chapter 21.
Other Measures
In addition to NPV, IRR, and payback, the following measures are occasionally used to evaluate capital projects. Their primary utility is to relate the level of NPV to the value of the investment or outflow. This can be useful in ranking projects based on their relative return.
Benefit‐Cost Ratio (BCR). The BCR is computed as follows:
For our illustration,
Profitability Index (PI). The PI is also used in ranking projects in capital rationing applications. Essentially it scales the NPV of the investment to each dollar of investment. The PI is computed as follows:
Step 3: Accept or Reject the Project
Financial theory provides that projects should be approved if the following requirements are met:
- IRR exceeds the discount rate.
- NPV is greater than 0.
- Payback < limit (e.g. 3 years).
Of course, these decision criteria must be applied in a sensible manner. Projects that marginally satisfy these requirements should be subjected to further review, including evaluating the projections and sensitivity and scenario analyses.
What Is a “Strategic Investment”?
Organizations (and most commonly CEOs) often refer to strategic investments as including any investment that is of strategic importance to the enterprise. This may include new products, geographic expansion, or even the acquisition of a firm. Many cynical CFOs jokingly refer to a strategic investment as any investment the CEO is firmly committed to that does not meet the economic criteria described previously! As a result, it is ascribed some unquantifiable “strategic value.”
In some cases, these projects may indeed have dubious value other than as a favorite initiative of the CEO. In other cases, this dichotomy arises because the analysis does not reflect all potential sources of value. The analyst should persevere to identify and estimate other scenarios and options that may not be reflected in the base case of the investment analysis. More on this in Chapter 21.
ILLUSTRATIONS
Two illustrations of capital investment decisions are presented next. The illustrations include the projected cash flows and the evaluation criteria for each investment. Table 20.5 is an example of an analysis of a project to automate manufacturing. Table 20.6 is an illustration of a new product development analysis. These examples were introduced earlier in the chapter to illustrate the identification of incremental cash flows for a project.
In both examples, the shaded part of the worksheet develops the incremental cash flows associated with the project. As discussed earlier in the chapter, each project will have unique characteristics and therefore unique cash flows. In addition to the incremental cash flow per year, we include the cumulative cash flow per year to highlight the timing of cash flows. Note that the cumulative cash flow for the new pharmaceutical remains negative through 2024 (six years) while the cumulative cash flow for the manufacturing project becomes positive in 2021 (three years).
The unshaded portion presents the economic evaluation of each project. In addition to presenting the project NPV, IRR, and payback, we include the present value factor and present value of cash flow for each year. This provides insight into the dynamics of the economic valuation, and the importance of accelerating cash flows in any project.
TABLE 20.5 Capital Expenditure: Manufacturing Project
| Vance Pharma Co. | Project Investment Analysis | $000's (Unless otherwise noted) | ||||||||
| Automate Manufacturing Process | ||||||||||
| Terminal | ||||||||||
| Incremental Changes | 2018 | 2019 | 2020 | 2021 | 2022 | 2023 | 2024 | 2025 | Value | |
| Revenues | ||||||||||
| Cost of Revenues | ||||||||||
| On Incremental Revenues | 30% | − | − | − | − | − | − | − | − | |
| Project Savings | − | −25,000 | −40,000 | −75,000 | −75,000 | −75,000 | −75,000 | −75,000 | ||
| Incremental Cost of Revenues | − | −25,000 | −40,000 | −75,000 | −75,000 | −75,000 | −75,000 | −75,000 | ||
| Gross Margin Impact | − | 25,000 | 40,000 | 75,000 | 75,000 | 75,000 | 75,000 | 75,000 | ||
| Operating Expenses: | ||||||||||
| On Incremental Revenues | 15% | − | − | − | − | − | − | − | − | |
| Project Savings | ||||||||||
| Project Costs and Expenses | 50,000 | |||||||||
| Depreciation on Project Capital | 30,000 | 30,000 | 30,000 | 30,000 | 30,000 | |||||
| Incremental Operating Expenses | 50,000 | 30,000 | 30,000 | 30,000 | 30,000 | 30,000 | − | − | ||
| Operating Profit | −50,000 | −5,000 | 10,000 | 45,000 | 45,000 | 45,000 | 75,000 | 75,000 | ||
| Tax | 40% | 20,000 | 2,000 | −4,000 | −18,000 | −18,000 | −18,000 | −30,000 | −30,000 | |
| Operating Profit After Tax | −30,000 | −3,000 | 6,000 | 27,000 | 27,000 | 27,000 | 45,000 | 45,000 | ||
| Operating Cash Flow: | ||||||||||
| Depreciation | 30,000 | 30,000 | 30,000 | 30,000 | 30,000 | |||||
| (Inc) Dec in Accounts Receivable | ||||||||||
| (Inc) Dec in Inventories | 50,000 | 25,000 | ||||||||
| Capital Expenditures | −150,000 | |||||||||
| Incremental Cash Flows | −180,000 | 77,000 | 61,000 | 57,000 | 57,000 | 57,000 | 45,000 | 45,000 | − | |
| Cumulative Cash Flow | −180,000 | −103,000 | −42,000 | 15,000 | 72,000 | 129,000 | 174,000 | 219,000 | ||
| Present Value Factor | 0.909 | 0.826 | 0.751 | 0.683 | 0.621 | 0.564 | 0.513 | 0.467 | ||
| Present Value of Cash Flows | −163,636 | 63,636 | 45,830 | 38,932 | 35,393 | 32,175 | 23,092 | 20,993 | ||
| NPV | $96,414 | |||||||||
| IRR | 28% | Discount Rate | 10% | |||||||
| Payback | 3 years | PH Growth Rate | 0% | |||||||
This project has a positive NPV, an IRR that exceeds the discount rate, and a relatively quick payback (3.0 years).
TABLE 20.6 Capital Expenditure: Pharmaceutical Product Development
| Vance Pharma Co. | Project Investment Analysis | $000's (Unless otherwise noted) | ||||||||
| New Treatment for Procrastination | ||||||||||
| Terminal | ||||||||||
| Incremental Changes | 2018 | 2019 | 2020 | 2021 | 2022 | 2023 | 2024 | 2025 | Value | |
| Revenues | − | − | − | 25,000 | 75,000 | 125,000 | 200,000 | 225,000 | ||
| Cost of Revenues | ||||||||||
| On Incremental Revenues | 25% | − | − | − | 6,250 | 18,750 | 31,250 | 50,000 | 56,250 | |
| Project Savings | − | |||||||||
| Incremental Cost of Revenues | − | − | − | 6,250 | 18,750 | 31,250 | 50,000 | 56,250 | ||
| Gross Margin Impact | − | − | − | 18,750 | 56,250 | 93,750 | 150,000 | 168,750 | ||
| Operating Expenses: | ||||||||||
| On Incremental Revenues | 15% | − | − | − | 3,750 | 11,250 | 18,750 | 30,000 | 33,750 | |
| Project Savings | ||||||||||
| Project Costs and Expenses | 20,000 | |||||||||
| Depreciation on Project Capital | 10,000 | 10,000 | 10,000 | 10,000 | 10,000 | |||||
| Incremental Operating Expenses | 20,000 | 10,000 | 10,000 | 13,750 | 21,250 | 28,750 | 30,000 | 33,750 | ||
| Operating Profit | −20,000 | −10,000 | −10,000 | 5,000 | 35,000 | 65,000 | 120,000 | 135,000 | ||
| Tax | 40% | 8,000 | 4,000 | 4,000 | −2,000 | −14,000 | −26,000 | −48,000 | −54,000 | |
| Operating Profit After Tax | −12,000 | −6,000 | −6,000 | 3,000 | 21,000 | 39,000 | 72,000 | 81,000 | ||
| Operating Cash Flow: | ||||||||||
| Depreciation | 10,000 | 10,000 | 10,000 | 10,000 | 10,000 | |||||
| (Inc) Dec in Accounts Receivable | − | − | −938 | −2,813 | −4,688 | −7,500 | −8,438 | |||
| (Inc) Dec in Inventories | − | −1,875 | −5,625 | −9,375 | −15,000 | −16,875 | −16,875 | |||
| Capital Expenditures | −50,000 | |||||||||
| Incremental Cash Flows | −62,000 | 4,000 | 2,125 | 6,438 | 18,813 | 29,313 | 47,625 | 55,688 | 371,250 | |
| Cumulative Cash Flows | −62,000 | −58,000 | −55,875 | −49,438 | −30,625 | −1,313 | 46,313 | 102,000 | 473,250 | |
| PV Factor | 0.870 | 0.756 | 0.658 | 0.572 | 0.497 | 0.432 | 0.376 | 0.327 | 0.284 | |
| PV Cash Flow | −53,913 | 3,025 | 1,397 | 3,681 | 9,353 | 12,673 | 17,904 | 18,204 | 105,532 | |
| NPV | $117,856 | Discount Rate | 15% | |||||||
| IRR | 37% | PH Growth Rate | 0% | |||||||
| Payback | 6 Years | |||||||||
This project has a positive NPV and an IRR that exceeds the discount rate. As expected, the payback (six years) is longer than the manufacturing example, but certainly acceptable for a product development initiative. Note that the discount rate of 15% is higher than that of the manufacturing project due to the higher level or risk (and therefore higher expected return) for developing a new product.
Monitoring Capital Investment Projects
After approving capital investment projects, organizations should have a process for tracking and evaluating the progress and revalidating the continued investment in resources. The critical assumptions and implementation progress can be compared to the original assumptions and project plan in the capital investment proposal (CIP).
This is especially important for mid‐ to long‐term projects such as product development. In these times of rapid change, it is entirely possible that the underlying assumptions for a project have changed to an extent that continued investment is not justified. Have market or competitive factors changed significantly? Will the product meet targeted cost and performance attributes? Similarly, implementation may have incurred delays or unforeseen hurdles that need immediate attention or may threaten the success of the project, including economic justification. Are we on schedule to introduce the product as planned? Will the project meet the expectations for revenue, profits, and NPV that were established in the CIP? By monitoring critical projects, early detection is possible, providing the greatest window for consideration and action. If the ongoing project is determined to be dubious, investments can be terminated and resources redirected to other, more promising opportunities. Venture capital firms are masters of using this method. Their continued investment in a firm or project is dependent on progress or the attainment of specific objectives that foretell ultimate success.
Organizations should also evaluate the performance of completed projects and review utilization of assets on a periodic basis. These topics are covered in Chapter 18, Capital Management and Cash Flow: Long‐Term Assets.
SUMMARY
Capital investment decisions are a critical aspect of managing an enterprise. Each CID requires a determination of whether that project will create value for the owners of the firm. Accordingly, firms must establish a rigorous process to allocate capital and evaluate individual uses of capital.
Capital investments include a wide spectrum of projects and purchases, from purchases of equipment to development of new products to acquiring a company. Common economic evaluation measures include payback, net present value, and internal rate of return.
Since CIDs require projections of future results, they incorporate a significant level of risk and uncertainty. Techniques for identifying and addressing risk and uncertainty are covered in Chapter 21.