Capital Investment Analysis

Capital investments (think: that new billion dollar battery factory) cost big bucks. So before writing that check, a detailed investment analysis needs to be done to be sure the dough isn't...wasted.

The capital analysis needs to predict whether or not the asset will produce earnings that exceed the cost of the asset. That's the basic magic flint that lights the light that turns green when the profits from that investment exceed the cost of doing it.

For example, if a cookie producer buys an automated machine that can produce 5,000 more cookies a day, will the earnings contributed from those incremental cookies exceed the $400,000 cost of the machine? And how long will it take to get the, uh...dough back?

Pro investors usually use techniques such as a net present value analysis or discounted cash flow. Since today’s money has more buying power than tomorrow’s, net present value is the difference between the present value of cash inflows (how many more cookies the company will sell) and the present value of cash outflows (the cost of the machine) over a specific period of time.

In other words, a positive net present value predicts that the earnings generated by the new machine exceed the costs. If the net present value is positive, the investment should be profitable. But if the investment has a negative net present value, it will probably result in a net loss. So...if the machine won’t pay for itself within three years, the project may not be approved.

It’s always wise to remember the garbage in, garbage out rule, i.e. the analysis is only as good as the numbers you enter. If you are too optimistic about future sales, for example, your net present value may not be accurate.