The Economics of Analyzing Capital Investments

Planning for capital assets involves a process of calculating the Net Present Value of the investment. Net Present Value is calculated by discounting the future changes in cash inflows and cash outflows using the weighted average cost of capital. The resulting present value of cash flows is compared to the Net Investment for the Capital Asset. The result is called Net Present Value. It should be noted that Net Investment includes all costs to place the capital asset into service plus any working capital requirements. If the capital asset has above average risks, than we would increase the weighted average cost of capital.

If the Net Present Value is positive, this indicates that value is added by making the investment. If the Net Present Value is negative, this indicates value destroyed. The objective is to have a total asset portfolio where the total Net Present Values are above zero. Besides Net Present Value, we can use Internal Rate of Return and Discounted Payback Period to evaluate capital projects.

Internal Rate of Return is the rate of return that the project earns. It is calculated by finding the discount rate whereby the total present value of cash inflows equals the total present value of cash outflows. Modified Internal Rate of Return can be used to remove the assumption that funds are reinvested each year at the Internal Rate of Return. We can also calculate the number of years it takes to recoup our Net Investment. Simply calculate a running total of the discounted cash inflows to determine the Discounted Payback Period.

Net Present Value, Internal Rate of Return, and Discounted Payback Period are three popular economic criteria for evaluating whether or not to invest in a capital asset. All three concepts give consideration to the time value of money. Estimating incremental cash flows is one of the most difficult steps in the overall evaluation process.