Capital Budgeting: Investment Decisions

Define capital budgeting:

Process of planning and controlling investments for long term projects. It is this long term aspect of
capital budgeting that presents the management accountant with specific challenges. Once made,
capital budgeting decisions tend to be relatively inflexible.

Define opportunity cost:

Maximum benefit forgone by using a scarce resource for a given purpose and not for the next best
alternative.

All capital budgeting decisions need to be evaluated on an after tax basis because taxes may affect
decisions differently. Companies that opearte in multiple tax jurisdictions may find the decision
process more complex. Another prossibility is that special tax concessions may be negotitated for
locating an investment in a given locale. T/F?

TRUE.

What types of costs should be considered in capital budgeting analysis:

Relevant cost and irrelevant costs

Define relevant cost:

Costs vary between different alternatives. Can be avoidable and may be eliminated by ceasing an
activity or by improving efficiency. An incremental cost is the increase in total cost resulting from
selecting one option instead of another.

Define irrelevant costs:

Do not vary between different alternatives and therefore do not affect the decision. A sunk or
commited cost would fall in this bucket.

What are the stages in capital budgeting:

Identification and definition. Search. Information acquisition.Selection.Financing and

implementation and monitoring.

Steps in ranking potential investments:

Determine the asset cost or net investment. Calculate estiamted cash flows. Relate the cash flow
benefits to their cost. Rank the investments.

Relevant cash flows:

Net initial invesment, annual net cash flows and project termination cash flows

Define risk analysis:

Attempts to measure the likelihood of the variablity of future returns from the proposed investment.
Risk cannot be ignored entirely, but mathematical approaches may be impossible because of a lack
of critical information.

Apporaches used to assess risk:

Informal method, risk adjusted discount rates, certainity equivalent adjustments, simulation
analysis, sensitivity analysis and the Monte Carlo technique.

Define real options:

Alternatives or choices that become available over the life of a capital investment.

Types of real options:

Abandoment, option to dely, option to expand, option to scale back, flexiblity option, capacity
option, new geographical market option, new product option, new product option.

Define certainity equivalent:

Guaranteed return that a company would accept over taking a risk on a higher but uncertain return.

Ordinary annuity (annuity in arrears)

Series of payments occuring at the end of each period. The first payment of an ordinary annuity is
discounted and interest is not earned for the first period of an ordinary annuity.

Capital Budgeting: Capital budgeting is the process of making investment decision in long-term assets or
courses of action. Capital expenditure incurred today is expected to bring its benefits over a period
of time.
These expenditures are related to the acquisition & improvement of fixed assets.
Capital budgeting is the planning of expenditure and the benefit, which spread over a number of
years.
It is the process of deciding whether or not to invest in a particular project, as the investment
possibilities may not be rewarding. The manager has to choose a project, which gives a rate of
return, which is more than the cost of financing the project. For this the manager has to evaluate the
worth of the projects in-terms of cost and benefits. The benefits are the expected cash inflows from
the project, which are discounted against a standard, generally the cost of capital.
Capital budgeting is used to make long-term planning decisions for investments in projects. These
projects could be the purchase of fixed assets or any other purchases or investments that will
provide benefit for a period of time greater than one year into the future. These are long-term
decisions, and they usually involve large amounts of money. Once a company has made a decision, it
is generally committed to it for a great deal of time. Therefore, it is critical to the company’s success
that its management makes correct decisions that will be profitable and beneficial in the long run.
Typical investment decisions include the decision to build another grain silo, cotton gin or cold store
or invest in a new distribution depot.
Investment Decisions, because it is an important part of the exam. You need to be very fluent in the
following areas:
• Calculating the cash flows for all of the years of a project, including the cash flows resulting from
the disposal of the assets at the end of the project.
• Calculating the Depreciation Tax Shield.
• Calculating the Net Present Value.
• Calculating the Internal Rate of Return.
• Determining which project to invest in.
• Calculating and using other covered methods such as the Payback Method and the Accounting
Rate of Return.

Term used in Capital Bugeting.

In the process of capital budgeting there are a number of different types of cash flows, revenues
and costs with which we need to be familiar, either to make sure that they are taken into account
in, or excluded from, the decision-making process.

Avoidable Cost An avoidable cost is one that can be avoided

or eliminated by making a decision not to
invest, or to cease investing. Because these
costs may be different among options, they
will be relevant costs that will need to be
addressed if the costs are different among the
options.
Committed Cost The company has already agreed to and
committed itself to a committed cost, even if
the invoicing or delivery of the product or
service has not taken place. A long-term
contract (for rent, for example) is an example
of a committed cost. This is similar to a sunk
cost in that it cannot be changed, but it is
different because the money has not yet been
spent. However, because the company is
committed to the cost, it will have a future
impact and therefore it needs to be recognized
as a cost that needs to be covered. But if the
committed cost cannot be changed by any
current decision, it is not relevant to a process
of deciding among alternatives currently,
because it will be the same no matter which
alternative is selected.
Common Cost A common cost is shared by all of the available
options or all divisions. Because it is the same
for all options, it is not relevant and should
not be taken into account in making a decision
between any two different options.
Cost of Capital The cost of capital is the weighted average
cost of interest on debt (net of tax) and the
implicit and explicit cost of equity capital. The
cost of capital is the minimum required rate of
return for a project in order to not dilute
(reduce) shareholders’ interest. The cost of
capital is often used as the discount rate in net
present value calculations.
Deferrable Cost, or Discretionary Cost A deferrable cost is one that can be deferred to
future periods without creating a significant
impact in the current period. Marketing and
training are often considered deferrable costs.
 Differential Revenue, Cost, or Cash Flow A differential revenue or differential cost or
differential cash flow is the difference in
revenue, cost, or cash flow between two
alternatives. A differential revenue, cost or
cash flow results from choosing one option
over another option, and these are the
important factors to consider when deciding
between two options. Differential revenues,
costs and cash flows are different from
incremental revenues, costs and cash flows
(see below).
Fixed Cost A fixed cost remains constant over the
specified level of activity (the relevant
range).
Opportunity Cost An opportunity cost is a forgone alternative
that had to be dismissed in order to achieve a
goal. Opportunity cost is the cost of the “next
best alternative” or the “next highest
valued alternative.” It is the price of not only
some other alternative that should be
considered, but also the highest other
opportunity that must be given up in order to
achieve one project.
Imputed Cost An imputed cost is an opportunity cost. An
imputed, or opportunity, cost is the benefit
that is given up as a result of using the
company’s resources elsewhere. It is the
benefit of the next best option. Another
definition of an imputed cost is one that is not
stated and must be calculated in some way.
Incremental Revenue, Cost, or Cash Flow An incremental revenue or incremental cost or
incremental cash flow is the additional
revenue, cost or cash flow from choosing an
activity over not choosing any activity, and
these are the important factors that need to be
taken into account when deciding whether to
embark upon a project.
Relevant Revenues, Costs or Cash Flows Relevant revenues, costs, or cash flows vary
with one course of action over another, and
they are the important factors in a decision,
because all other revenues, costs and cash
flows are the same for all options. Relevant
revenues, costs, or cash flows may be either
incremental or differential.
Sunk Costs A sunk cost is one that has already been
incurred and therefore is not a relevant cost.
Sunk costs are not taken into account in
decision-making because the money has
already been spent, and any new decision will
not change those costs.

Important calculations:

1. Initial investment
2. Operating cashflows

Capital Budgeting methods:

1.Payabck period (Traditional and Discounted)
2.Net Present Value
3.Profitability Index
4.Internal Rate of Return
5.Accounting(Average) Rate of Return

Risks in Capital Budgeting:

- Market Risk
- Non Market Risk

Real Options in Capital Budgeting:

 Expand
 Adapt
 Postpone
 Abandon

Incremental Cash Flows (ICF)

Incremental cash flow is the additional cash inflow which the company
generates from investing in any specific project. ICF shows the difference
between company net cash flow if the project is accepted and net cash flow if
the project is not accepted. It is a tool that helps management to decide
whether to invest in a new project or not. The new project may make a profit
in the future, however, if taking it to cause a cash flow issue and affect a whole
company, so the management needs this information in order to make a
proper decision.

The positive incremental cash flow is a goods sign for the company to make a
new investment, but it may not tell the whole story. Management needs to
check with other information, as the ICF has many limitations which we can
see in the next section. It should not be the only resource for the company to
rely on and decide on new investments. Even the negative ICF, it does not
mean that we should abandon the investment immediately.

Formula

Incremental Cash Flows Example

ABC is considering investing in new machinery which costs $ 500,000. It has a
useful life of 5 years with a scrap value of $ 50,000. Base on the projection, the
company will be able to increase the sale of $ 1 million per year with 40% of
variable cost.

What is the incremental cash flows of this project?

The cash inflow over the project is $ 5,000,000 ( $ 1,000,0000 * 5 years)

The cash outflow over the project is $ 2,000,000 (40% of the sale is variable
cost)

ICF =$ 5,00,000 – $ 2,000,000 – $ 500,000 = $ 2,500,000

Difficulty in Preparing Incremental Cash flows
Difficulty

ICF only looks into the future and predicts the cash flow,
Sunk Cost which means that we have ignored the sunk cost which is
already incurred.

Moreover, this tool does not include the opportunity cost

Opportunity which results from investing in a new project. The company
Cost may use this cash for other tasks such as purchase a more
fixed asset which enables it to increase production.

Cost allocation will be a problem when more projects are

Cost allocation created. We need to have proper accounting software as
well as a strong team to work out on this task.

It happens when the company invest in a new project

which takes the revenue from their existing project. So in
Cannibalizatio
total, the whole business does not create any new sale or
n
profit. They just separate the sale and profit from the
existing one.

The future cash flow is based on past data, management

experience and the estimation, so they are highly likely to
Base on
be incorrect. Even we can get it right, the result may
prediction
change due to the external factors which we don have
control such as political, economic, technology and so on.

How to calculate incremental cash flow in

Excel
In order to help with incremental cash flow calculation, we have built Excel
template to analyze the cash inflow and cash outflow for new investment on
new machinery.

We need to find the components below to fill in the template:

 Purchase price: the cost we spend on the new asset

 Scrap Value: the estimated scrap value at the end of asset useful life
  Proceed from old asset: if we need to sell the old asset and replace it
with the new one.
 Sale increase: the estimated sale increase raise from new assets, not the
total sale.
 Variable Cost: The variable cost associate with sale increase only, not the
total sale.
 Increase of fixed cost: if fixed cost change due to increase of operation.
Ignore it if fixed cost remains the same.

Based on this information, we decide to accept the project only when the total
incremental cash flow is positive.

What is Incremental Cash Flow?

Incremental cash flow refers to cash flow that is acquired by a company
when it takes on a new project. To estimate an incremental cash flow,
businesses must compare projected cash flow if it takes on a new project to
when it doesn’t, putting into consideration how accepting such project may
affect the cash flow of another part of the business.
In the event that a reduction in the cash flow of another aspect or product
is the result of taking on a new project, then it is called cannibalization.
Incremental cash flow is important in capital budgeting because it helps
predict cash flow in the future and determine a project’s profitability.

Difficulties in Determining Incremental Cash Flow

Incremental cash flows are helpful, especially in determining if a company

should take on a new project or not. However, accountants also encounter
certain difficulties when estimating incremental cash flow. Here are some of
the challenges:

1. Sunk costs

Sunk costs are also known as past costs that have already been incurred.
Incremental cash flow looks into future costs; accountants need to make
sure that sunk costs are not included in the computation. This is especially
true if the sunk cost happened before any investment decision was made.

2. Opportunity costs

From the term itself, opportunity costs refer to a business’ missed chance
for revenues from its assets. They are often forgotten by accountants, as
they do not include opportunity costs in the computation of incremental
cash flow.

One example is a company that specializes in sound system installations

that skips a project that requires the use of five sets of boom boxes.
Currently, the business is only putting the five extra sets of boom boxes in
its storage facility, instead of taking on the project that will earn $5,000.
This illustrates the opportunity cost of $5,000.
3. Cannibalization

As mentioned above, cannibalization is the result of taking on a new project

that reduces the cash flow of another product or line of business. For
example, an owner with an existing mall that caters to classes A and B, and
everything it sells is sold at a premium because it caters to luxury shoppers.

In another part of the same city, it decides to open a new mall that caters to
classes B, C, and D, selling the same items as the other mall but at a
significantly lower price. This will result in cannibalization because some
people will no longer go to the first mall because they can get most things
at the new mall for a much lower price.

4. Allocated costs

These are some costs that must be allocated to a specific department or

project and there may not be a rational way to do it (i.e. rent expense)..

Incremental Cash Flow vs. Total Cash Flow

Incremental cash flow and total cash flow both deal with a business’ or
project’s cash flow. However, they are notably different from each other.

 Incremental cash flow analysis tries to predict the future cash flow
of a business if it takes on a new project. It helps management
determine if a project is worth doing or not. Projects will be
considered if it is a positive incremental cash flow is generated, and
declined if negative cash flows are expected.
 Total cash flow analysis determines the total cumulative cash that’s
been generated from doing a project or evaluating a business. For
example, when a CEO wants to see the total cash flow of the
company from each of the preceding five years. To come up with the
correct figure, all the cash flows from each year in the last five years
are put together.
What is Incremental Cash
Flow?
Incremental cash flow is the cash flow realized after a new project is
accepted or a capital decision is taken. In other words, it is basically
the resulting increase in cash flow from operations due to the
acceptance of new capital investment or a project.
The new project can be anything from introducing a new product to
opening a factory. If the project or investment results in positive
incremental cash flow, then the company should invest in that
project as it would increase the company’s existing cash flow.

But what if one project is to be chosen and multiple projects have

positive incremental cash flows? Simple, the project with the
highest cash flows should be selected. But ICF shouldn’t be the
only criteria for choosing a project.

Incremental Cash Flow Formula

Incremental Cash Flow = Cash Inflow – Initial Cash Outflow –
Expense

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Components
When considering a project or analyzing it through cash flows of
that project, one must have a holistic approach rather than looking
at only inflow from that project. Incremental cash flow thus has
three components to it –
 #1 – Initial Investment Outlay
It is the amount needed to set up or start a project or a business.
E.g., a cement manufacturing company plans to set up a
manufacturing plant at XYZ city. So all the investment from buying
land and setting up a plant to manufacturing the first bag of
cement will come under initial investment (remember, initial
investment does not include sunk cost)
#2 – Operating Cash Flow
Operating cash flow refers to the amount of cash generated by that
particular project, less operating, and raw material expense. If we
consider the above example, the cash generated by selling cement
bags less than the raw material and operating expenses like labor
wages, selling and advertising, rent, repair, electricity, etc. is
the operating cash flow.
#3 – Terminal Year Cash Flow
Terminal cash flow refers to net cash flow that occurs at the end of
the project or business after disposing of all the assets of that
particular project. Like in the above example, if the cement
manufacturer company decides to shut down its operation and sell
its plant, the resulting cash flow after brokerage and other costs
is terminal cash flow.

 So, ICF is the net cash flow (cash inflow – cash outflow) over a
specific time between two or more projects.
 NPV and IRR are other methods for making capital budgeting
decisions. The only difference between NPV and ICF is that while
calculating ICF, we do not discount the cash flows, whereas, in NPV,
we discount it.
 Examples
 A US-based FMCG company XYZ Ltd. is looking to develop a new
product. The company has to make a decision between soap and
shampoo. Soap is expected to have a cash flow of $200000 and the
shampoo of $300000 during the period. Looking only at the cash
flow, one would go for shampoo.
 But after subtracting expense and initial cost, soap will have an
incremental cash flow of $105000 and shampoo of $100000 as it
has a greater expense and initial cost than soap. So going only by
the incremental cash flows, the company would undertake the
development and production of soap.
 One should also consider the negative effects of undertaking a
project as accepting a new project may result in a reduction in the
cash flow of other projects. This effect is known as Cannibalization.
Like in our above example, if the company goes for the production
of soap, then it should also consider the fall in cash flows of existing
soap products.

XYZ Ltd

Particular Soap Shampoo

Cash Flow $200,000 $300,000

Less: Expense $60,000 $135,000

Less: Initial Cash outflow $35,000 $65,000

Incremental Cash Flow (ICF) $105,000 $100,000

 Advantages
It helps in the decision of whether to invest in a project or which
project among available ones would maximize the
returns. Compared to other methods like Net present value (NPV)
and Internal rate of return (IRR), Incremental cash flow is easier to
calculate without any complications of the discount rate. ICF is
calculated in the initial steps while using capital budgeting
techniques like NPV.

Limitations
Practically incremental cash flows are complicated to forecast. It is
as good as the inputs to the estimates. Also, the cannibalization
effect, if any, is difficult to project.

Besides endogenous factors, there are many exogenous factors that

may affect a project greatly but are challenging to forecast like
government policies, market conditions, legal environment, natural
disaster, etc. which may impact incremental cash flows in
unpredictable and unexpected ways.

 For example – Tata steel acquired the Corus group for $12.9 billion
in 2007 to tap and enter into the European market as Corus was one
of the largest steelmakers in Europe that produced high-quality
steel and Tata was a low quality steel producer. Tata forecasted the
cash flows and benefits arising out of acquisition and also analyzed
that the cost of acquisition was less than the setting up its plant in
Europe.
 But many external and internal factors led to a slump in steel
demand in Europe, and Tata’s were forced to shut down its acquired
plant in Europe and are planning to sell some of its acquired
business.
 So, even large companies like Tata steel couldn’t accurately predict
or forecast market conditions and, as a result, suffered huge losses.
 It cannot be the sole technique for selecting a project. ICF in itself is
not sufficient and needs to be validated or combined with other
capital budgeting techniques that overcome its shortcomings like
NPV, IRR, Payback period, etc. which, unlike ICF, considers
the TVM.

Incremental Cash Flows

What is the incremental cash flow?
Incremental cash flow is the extra cash flow a business will generate
by investment in a new project over and above its existing cash
flow. It helps the company’s management to decide whether to go
for the new investment or not. Calculation of the difference between
the current cash flow of the company and the future cash flow of the
company after investing in the new project is done. If the difference
is positive and considerable, the management shall go ahead with
the project. If not, they should shelve the new idea.
 One thing to note is that the company cash flow to use for
comparison is the net cash flow. Thus, it means that adjustment
shall be done for all the additional expenditures the company will
have to bear for the implementation of the new project. Positive
cash flow is important to enable the company to meet its day-to-day
cash expenses, interest expenses, taxes, buy essential assets for
work, and to pay for regular repairs and maintenance.

Table of Contents

1. What is the incremental cash flow?

2. How to calculate the incremental cash flow?
1. Example of incremental cash flow
1. Interpretation and analysis of the result
3. Uses of incremental cash flow
1. Payback period
2. Accounting rate of return
3. Net present value
4. Internal rate of return
5. Profitability index
4. Limitations of incremental cash flow
1. Unpredictable internal and external factors
2. Sunk costs and opportunity costs
3. Cannibalization
4. Difficult to identify
5. Summary

How to calculate the incremental cash

flow?
Calculation of incremental cash flow is done by adding the total cash
inflow from the new project under consideration. And then
deducting all the initial expenditure for setting up the facilities and
further operational expenses on that project.

Cash flow from the new idea or project= Total cash inflow
from that project – (Initial cash expenditure or outflow +
Expenses on the project)

This is the net cash flow the company may get by investing in this
new idea or project or facilities. The decision to go ahead and make
investment or not hinges upon the quatum and time period of this
cash flow.
Example of incremental cash flow
Let us suppose that a company XYZ Pvt. Ltd. plans to launch a new
product “A”. The expected revenue from the product in the first year
of launch is US$50000. The estimation of the expenses the company
will incur on the new product over the year is US$10000. Also, the
initial set-up cost for the production of the product is US$20000.

Calculation of the incremental cash flow from this new product A is:

US$50000 – (US$10000 + US$20000)

= US$20000 in the first year of launch.

Now let us assume that the company has the option of launching
another product “B”. The expectation of revenue from the product in
the first year of launch is US$300000. The estimation of the
expenses the company will incur on the new product over the year
is US$150000. Also, the initial set-up cost for the production of the
product is US$120000.

Therefore, the calculation for the incremental cash flow from this
new product B will be:

US$300000 – (US$150000+ US$120000)

= US$ 30000 in the first year of launch.

Interpretation and analysis of the result

The incremental cash flow or net cash flow from product B is higher
by US$10000 and hence, the company should opt for it according to
the concept, prima facie. However, if we observe closely and in
detail we notice that product “A” is giving an incremental cash flow
of US$20000 on a total revenue of just US$ 50000. These figures
are US$30000 on total cash inflows of US$300000 for product B. It
means the ratio or percentage of net positive cash inflow for Product
A is way higher than that of Product B.
Moreover, this net cash inflow is again on a investment or cash
outflow of just US$ 20000 for Product A, whereas for Product B the
net cash flow is on the investment of US$ 120000. It is again quite
disproportionate. Therefore, in such situations incremental cash flow
only may not give the correct picture and may lead to wrong
decisions.

Hence, it is important to use other capital budgeting techniques too

along with incremental cash flow to ascertain the viability of any
investment or project. These techniques can be payback
period, accounting rate of return, net present value, internal rate of
return, or a profitability index, etc.

Uses of incremental cash flow

Payback period
The payback period is the time period that a company will take to
recover its investment from a particular project. The net positive
cash inflow every operating year can differ and generally increases
as the year gone by. Under this method we go on adding the yearly
cash flows till it becomes equal to the initial investment. And
therefore, the point of this equality or the strech of that period,
expressed in terms of years becomes the pay back period.

The standard principle generally followed is the shorter is the pay

back period of a project, between the competing projects, better
and preferable it would be. Because, the company will get back the
initial investment at the earliest possible and to that extent
probability and riskiness of the project will reduce.

Accounting rate of return

The accounting rate of return calculates the percentage return a
company receives from an investment or a project. Also, it does not
take into account the time factor. Calculation of net income is done
by subtracting various expenses from the total revenue generated
from the project. This income is used to calculate the percentage
return from the project.
Again the standard principle is to prefer and go for a project having
the higher rate of return.

Net present value

Calculation of the net present value involves using the present value
of cash outflows and cash inflows over a period of time. Subtraction
of the present values of cash outflows is done from that of the cash
inflows and it should be positive. This method is used along with
incremental cash flow to ascertain the profitability of any investment
or project. This concept is an advancement over the pay back period
methodology.

The payback period method ignores the time value of money. This
technique takes care of that. It could happen that two projects may
have similar pay back period. However, the quantum of cash flow in
the initial years is more say in Project A. Whereas Project B has
more or less equal cash flows all the years or Project B may be
having large inflows in the later years.

Therefore it is obvious and prudent to prefer Project A over Project

B. Though payback period is same for both the projects.

Internal rate of return

Companies use the internal rate of return for finding out the
feasibility of investment. It is a form of a discount rate. The net
present value of all the cash flows is discounted to zero at this rate.
Also, it does not include external factors like inflation, cost of
capital, etc. Thereafter, companrison takes place between this
discount rate at which the Prensent Values becomes zero with the
cost of capital of the company.

And if the discount rate so obtained from the project analysis is

higher then the cost of capital of the company, then the project
seems acceptable.
Profitability index
The profitability index is a financial ratio of payoff to investment
amount in case of a new project. It compares the present value of
the incremental cash flow arising from a project with the investment
amount. Thus, a proposed investment will be more lucrative with a
high profitability index and vice-versa.

Limitations of incremental cash flow

Unpredictable internal and external factors
The internal and external factors that can affect the incremental
cash flow from a project are unpredictable. Change in internal
policies and priorities of the management. And external factors like
government rules and regulations, inflation, market conditions,
interest rates, etc. can anytime change. These can directly affect
the future cash flow calculations and hence, make the concept
unreliable.

Sunk costs and opportunity costs

The concept is based on future cash flows and expenditure. But it
does not include sunk costs that may have already been incurred
before the new project is virtually taken up. Also, it does not take
into account the concept of opportunity cost. While it calculates the
incremental cash flow from a new project; it does not account for
the cost of the missed opportunity of investing in some other project
and benefitting from it.

Cannibalization
Cannibalization is the concept of a new project or investment eating
into the future cash flows of other existing projects of the same
company. For example, let us take the case of the launch of a new
brand of clothes by a clothing company. It may eat into the market
share of its already existing brands of clothing. The incremental
cash flow from the new brand may be positive. But it is possible that
the loss of sales from the older brands may be more. Hence, the
new project may prove to be loss-making rather than being
profitable for the company.
Difficult to identify
A company may not be able to calculate the incremental cash flows
from a new product correctly in case of companies having a wide
range of product mix. The future cash flow may be from a mix of
items that will make it difficult to correctly attribute the sale to a
particular product or project.

Summary
Incremental Cash Flow is an important tool for ranking or deciding
between the two competing and mutually exclusive projects. The
net positive cash flow from the new project is worked out and added
to the existing cash flow of the company. As marginal cost is the
extra expense incurred for producting that extra unit. Similar way,
the incremental cash flow is the additional and extra cash flow
generation from the new project or investment. However, all
indicators need to be interpreted and concluded upon together with
other indicators and ratios. In isololation, it may not give the correct
picture or lead to a right decision.

What is a Capital Investment Model?

Most companies make long-term investments that require a large amount
of capital invested in the initial years, mostly in fixed assets such
as property, machinery, or equipment. Due to the significant amount of
cash outflows required, companies perform a capital investment analysis to
evaluate the profitability of an investment and determine whether it is
worthy. This is especially important when a business is presented with
multiple potential opportunities and needs to make an investment decision
based on the long-run returns they can get.

To assess the profitability of a capital investment, companies can build a

capital investment model in Excel to calculate key valuation metrics
including the cash flows, net present value (NPV), internal rate of return
(IRR), and payback period.
In this guide, we will outline the major line items that should be included in
a capital investment model and how to use the calculated metrics to
evaluate the investment.

#1 Revenues, Expenses and Profit

The first step to building a capital investment model is to determine the

cash flows for the investment period. In this simplified model, we are
presenting the income statement using the minimal number of line items –
revenue, expenses, and profit. By subtracting the expenses from the annual
revenue we can determine the profit for each year within the investment
period, which will be used as cash inflows for the capital investment.
#2 Capital Investment and Cash Flow

Next, we need to determine the amount of capital invested in the project,

which equals the cash outflows during the investment period. With that
information, we can then calculate the annual cash flows using the
following formula:

Cash Flow (Annual) = Profit – Capital Investment

The cash flow line will be the major input in the calculations of net present
value (NPV) and internal rate of return (IRR) for this capital investment.

We also need to determine the cumulative cash flow, which is essentially

the sum of all cash flows expected from the investment. The cumulative
cash flow figures will be used to compute the payback period of the
investment.

#3 Net Present Value (NPV)

The net present value (NPV) is the value of all future cash flows over the
entire life of the capital investment discounted to the present. In this
example, we will determine the NPV using three different discount rates –
10%, 15%, and 20%. This rate is often a company’s weighted average cost
of capital (WACC), or the required rate of return investors expect to earn
relative to the risk of the investment.

In Excel, you can use the NPV function to find the present value of a series
of future cash flows with equal time periods. The formula for the NPV
function is = NPV(rate, cash flows).

In this example, the NPV of this capital investment would be $120,021 when
the discount rate is 10%, $77,715 when the discount rate is 15%, and
$48,354 when the discount rate is 20%. It tells us that when there is a
higher risk associated with a capital investment, investors expect to pay less
today and a higher return in the future.
#4 Internal Rate of Return (IRR)

The internal rate of return (IRR) is the expected compound annual rate of
return earned on a capital investment. IRR is usually compared to a
company’s WACC to determine whether an investment is worthy or not. If
the IRR is greater than or equal to the WACC, then the company would
accept the project as a good investment. Vice versa, the company would
reject the investment if the IRR is less than the WACC.

You can use the IRR function in Excel to compute the rate of return based
on a series of future cash flows. The formula for the IRR function is
=IRR(rate, cash flows).

#5 Payback Period

The last metric to calculate for a capital investment is the payback period,
which is the total time it takes for a business to recoup its investment. The
payback period is similar to a breakeven analysis but instead of the number
of units to cover fixed costs, it looks at the amount of time required to
return the investment.

A simple way to calculate the payback period is to count the number of

periods until the company earns a positive cumulative cash flow on the
investment. In the example provided, the company starts to have positive
cumulative cash flow in year 5 and, thus, the payback period for this
investment is 5 years.

#6 Cash Flow Chart

Besides calculating the payback period, a cash flow chart is also a good way
to visualize the cash flow trend over the investment period and the time
when the investment breaks even. In the example above, the column chart
in blue represents the annual cash flow of the investment, while the line
chart in orange shows the cumulative cash flow over the period.

The point where the orange line intersects with the horizontal axis is the
breakeven point, where the company earns zero cumulative cash flow and
begins to recognize positive cash flow after paying back all of the initial
investment.

9.8: Capital investment analysis

https://biz.libretexts.org/Bookshelves/Accounting/Book
%3A_Principles_of_Managerial_Accounting_(Jonick)/09%3A_Differential_Analysis/
9.08%3A_Capital_investment_analysis

One of a company’s most significant financial decisions involves the purchase of property,
plant, and equipment that will be used in business operations. The costs of these assets are
often very high, and they will be in place for many years to come.

Before acquiring a capital asset such as equipment, machinery, or a building, which involves
a large expenditure and long-term commitment, a company should evaluate how effectively it
is expected to generate a return on investment for the business. Capital investment
analysis is a form of differential analysis used to determine (1) whether a fixed asset should
be purchased at all, or (2) which fixed asset among a number of choices is the best
investment. Three commonly used methods for evaluating capital investments will be
discussed.

The first two, the average rate of return method and the cash payback method, are relatively
straightforward calculations that are often used to determine whether a proposed investment
meets a minimum standard for it even to be considered further.

The average rate of return method is the percentage return of net income from the
proposed investment. It is calculated as follows:

Average annual incomeAverage investment Average annual incomeAverage investment

Each of the two amounts must first be calculated independently.

Average annual income (numerator) = Total estimated income over the asset's useful
Average annual income (numerator) = Total
life Number of years in the asset's useful life
estimated income over the asset's useful life Number of years in the asset's useful life

Average investment (denominator) = Book value at the beginning of the first

Average investment (denominator) = Book
year 1+ Book value at the end of the last year 22
value at the beginning of the first year 1+ Book value at the end of the last year 22
1
The book value at the beginning of the first year is the asset’s cost.
2 The book value at the end of the last year is the asset’s residual value.

As an example, a new piece of equipment that is being considered for purchase costs $90,000
and has a residual value of $10,000. It is expected to generate revenue of $75,000 over its
estimated useful life of 5 years.

Average annual income=$75,0005=$15,000 Average annual

income=$75,0005=$15,000

Average investment=$110,000+$10,0002=$60,000 Average investment=$110,000+

$10,0002=$60,000

Average investment=$15,000$60,000= 25 Average investment=$15,000$60,000= 25%

The average rate of return of 25% should then be compared to the minimum rate of return
that management requires. If the average rate of return is greater than the minimum
acceptable rate, the equipment should be evaluated further since it seems promising. If it does
not even meet this standard, however, it should not be purchased.

The cash payback method looks at the annual net cash inflow from the use of an asset to
determine how many years it will take to recover the cost of the asset. Net cash flow includes
all cash revenue generated minus all cash expenditures paid from using the asset.
Depreciation is not a cash expenditure, so it would not be considered in determining net cash
flow.

As an example, a new piece of equipment that is being considered for purchase costs
$80,000. It is expected to generate $25,000 cash revenue each year and require cash
expenditures of $5,000 to maintain.

Cash payback period $=\frac{\text { cost }}{\text { Annual nest cash flow }}=\frac{\$
80,000}{\$ 25,000-\$ 5,000}=4$ years

The cash payback period of four years should be compared to the maximum period that
management desires. If the cash payback period of four years is more than an acceptable
payback period of three years, for example, the purchase should no longer be considered. If a
payback period of five years is acceptable, the purchase should be looked into further.

If annual net cash flows are not expected to be equal each year, the cash payback period is
determined by adding the annual expected cash flows year by year until the sum equals the
initial cost of the asset.

For example, a new piece of equipment that is being considered for purchase costs $80,000.
Its expected annual cash flows are as follows:

Year Net Cash Flow Cash Flow to Date

1 $12,000 $12,000
2. 18,000 30,000
3 24,000 54,000
4 26,000 80,000
5 30,000 110,000
6 34,000 144,000

In this case, net cash flows recover the initial cost of $80,000 after four full years. The
average rate of return and the cash payback methods are relatively simple to calculate, yet
they yield rather general results. Since neither considers the time value of money, they are
more effective for shorter-term investments. They are often used as an initial screening to see
if an investment should be immediately disqualified. If not, the investment may be analyzed
further using more robust

analyses.
The net present value (NPV) method for evaluating a potential investment

also looks at estimated future net cash flows generated by the asset. It compares the purchase
price (investment amount) to the present value of all the future net cash flows from using the
asset. The investment is considered viable if the present value of the future net cash flows is
greater than the purchase price. Otherwise, the investment should be avoided.

Present value factors the timing of future net cash inflows and the effect of a prevailing
interest rate. An amount of cash received in the future is worth less than the same amount of
cash received today. This is because cash received now may be invested at a given interest
rate that causes its value to grow over time compounding, where interest is earned both on
principal and on interest that has already been earned. The opportunity to invest dollars
received in the future rather than today is postponed, missing out on time available to earn
interest.

Determining the future value of a current amount is calculated by multiplying the amount by
itself plus the interest rate. For example, the future value of $1.00 in 3 years at an interest rate
of 6% would be calculated as follows:

$1.00 x 1.06 = $1.06 x 1.06 = $1.12 x 1.06 = $1.19

Note that interest is calculated on interest previously earned. This process is called
compounding.

Present value works in the opposite direction. An amount in the future is known or estimated
(such as a net cash inflow), and the calculation backs that amount up to its current value. The
process is called discounting. For example, the present value of $1.00 to be received in 3
years at an interest rate of 6% would be calculated as follows:

$1.001.06=$0.941.06=$0.891.06=$0.84(rounded to the nearest

cent) $1.001.06=$0.941.06=$0.891.06=$0.84(rounded to the nearest cent)

The following table summarizes the present value of $1 for 10 periods for three interest rates:
6%, 8%, and 10%. Amounts are rounded to five decimal places rather than to the nearest
cent.

Present Value of $1
Period 6% 8% 10%
1 0.94340 0.92593 0.90909
2 0.89000 0.85734 0.82645
3 0.83962 0.79383 0.75132
4 0.79209 0.73503 0.68302
5 0.74725 0.68058 0.62093
6 0.70495 0.63017 0.56448
7 0.66505 0.58349 0.51316
8 0.62741 0.54027 0.46651
9 0.59190 0.50025 0.42410
10 0.55840 0.46319 0.38555

Note that all amounts in the present value table are less than $1.00 since all represent a future
cash receipt rather than the $1.00 today. The further into the future the $1.00 will be received
for a given interest rate, the lower its present value.

Clearly not all future cash receipts are for $1.00. To get the present value of a different value,
multiply the actual number of dollars by the present value of $1 amount given in the table at
the intersection of a specified interest rate and number of years.

Examples 1 and 2 illustrate the process of discounting the future net cash flows to determine
their total and comparing it to the cost of the asset.

Example

A company is considering purchasing equipment #1 for $100,000. It is expected to provide

net cash flows of $24,000 per year for the next six years for a total of $144,000. The
minimum desired rate of return on the investment is 6%.

Present
Undiscounted Discounted Since the undiscounted net cash flow
Value
Year Net Cash Net Cash amount is the same each year, the total
of $1 at
Flow Flow discounted net cash flow could also be
6%
calculated by using the present value of
1 $24,000 0.94340 $22,642
an annuity of $1, as follows:
2 24,000 0.89000 21,360
3 24,000 0.83962 20,151 $24,000 x 4.91731 = $118,016
4 24,000 0.79209 19,010
5 24,000 074725 17,934 Rather than multiplying $24,000 six
6 24,000 0.70495 16,919 times by six different factors, $24,000
Total $144,000 4.91731 $118,016 can be multiplied once by the sum of all
the factors
Cost (100,000)
(4.91731). The result is the same.
NPV $18,016
In this case, the net present value of the future cash flows of $18,016 is greater than the cost
of the asset, $100,000. The investment may be accepted since it more than pays for itself over
time.

If the cost of the asset had been $130,000 rather than $100,000, the net present value would
have been ($11,984), which is $118,016 - $130,000. In this case the NPV is negative and the
proposed purchase should be rejected.

Example

A company is considering purchasing equipment #2 for $100,000. It is expected to provide

net cash flows of different amounts each year for the next six years for a total of $144,000.
The minimum desired rate of return on the investment is 6%.

Present
Undiscounted Discounted
Value
Year Net Cash Net Cash
of $1 at
Flow Flow
6%
Since the undiscounted net cash flow
1 $34,000 0.94340 $32,076 amounts are different each year, the
2 30,000 0.89000 26,700 total discounted net cash flow must be
3 26,000 0.83962 21,830 calculated using six individual
4 24,000 0.79209 19,010 calculations. Each year the
5 18,000 074725 13,451 undiscounted net cash flow amount is
6 12,000 0.70495 8,459 multiplied by the present value of $1
Total $144,000 $121,526 factor at 6%.

Cost (100,000)
NPV $24,526

In this case, the net present value of the future cash flows of $21,256 is greater than the cost
of the asset, $100,000. The investment may be accepted since it more than pays for itself over
time.

Net present value can be used to perform differential analysis to compare results of two or
more proposed investments to determine which is more financially beneficial. Examples 3
and 4a show these comparisons.

Example

A company is considering two different proposals for purchasing equipment. Both assets will
be useful for six years. The first piece of equipment costs $100,000, and the second costs
$140,000. The undiscounted cash flows appear in the two tables that follow.

Presen Presen
Undiscounte Discounte #2 Undiscounte Discounte
#1 t Value t Value
d Net Cash d Net Cash Yea d Net Cash d Net Cash
Year of $1 of $1
Flow Flow r Flow Flow
at 6% at 6%
1 $34,000 0.94340 $32,076 1 $44,000 0.94340 $41,510
2 30,000 0.89000 26,700 2 39,000 0.89000 34,710
3 26,000 0.83962 21,830 3 34,000 0.83962 28,547
4 24,000 0.79209 19,010 4 31,000 0.79209 24,555
5 18,000 074725 13,451 5 23,000 074725 17,187
6 12,000 0.70495 8,459 6 16,000 0.70495 11,279
Total $144,000 $121,526 Total $187,000 $157,788
Cost (100,000) Cost (140,000)
NPV $24,526 NPV $17,788

The second piece of equipment has a higher estimated net cash flow each year, but it also
costs more to purchase. Both assets yield a positive net present value, but the first piece of
equipment has a higher NPV, $21,526, vs. the NPV of the second piece, $17,788. The first
piece of equipment should be purchased based on this result.

It is possible that two different investments will span two different periods; that is, one may
generate cash flows for more years than the other. In order to perform a differential analysis,
the number of years must be the same for both. To make them comparable, the asset with the
higher number of years of cash flows is adjusted to assume that it is sold for its residual value
amount in the last year that the other asset provides cash flows.

Example

A company is considering two different proposals for purchasing equipment. The first asset
provides cash flows for four years, and the second one provides cash flows for six years. Both
assets cost $100,000 and have a residual value of $10,000. Both have undiscounted net cash
flows of $124,000 as shown in the tables that follow.

Presen Presen
#1 Undiscounte Discounte Undiscounte Discounte
t Value #2 t Value
Yea d Net Cash d Net d Net Cash d Net
of $1 Year of $1
r Flow Cash Flow Flow Cash Flow
at 6% at 6%
1 $38,000 0.94340 $35,849 1 $34,000 0.94340 $32,076
2 34,000 0.89000 30,260 2 32,000 0.89000 28,480
3 30,000 0.83962 25,189 3 26,000 0.83962 21,830
4 22,000 0.79209 17,426 4 22,000 0.79209 17,426
4
(residual 10,000 0.79209 7,921
)
5 18,000 0.74725 13,451
6 12,000 0.70495 8,459
Total $124,000 $108,724 Total $124,000 $107,733
Cost (100,000) Cost (100,000)
NPV $8,724 NPV $7,733

Note that the cash flow period for the second piece of equipment is adjusted to four years to
match that of the first piece of equipment. There are two net cash flows for the second piece
of equipment in year four: (1) the inflow from using the equipment, and (2) the proceeds
from selling it at its residual value. The cash flows for the fifth and sixth years for the second
asset are not considered and are therefore greyed out in the table.

Both assets yield a positive net present value, but the first piece of equipment has a higher
NPV, $8,724, vs. the NPV of the second piece, $7,733. The first piece of equipment should
be purchased based on this result.

As a final illustration of two companies with different cash flow periods, note that the net
present value would be identical if the annual net cash flows were the same. In this case, all
are equal in years 1, 2, and 3. In year 4, they also both equal $32000: for the first asset the
$32,000 is all operational cash flow, and for the second piece of equipment, the $32,000
includes $22,000 of operational cash flow and $10,000 selling price.

Example

A company is considering two different proposals for purchasing equipment. The first asset
provides cash flows for four years, and the second one provides cash flows for six years. Both
assets cost $100,000 and have a residual value of $10,000. Both have undiscounted net cash
flows of $124,000 as shown in the tables that follow.

Presen Presen
#1 Undiscounte Discounte Undiscounte Discounte
t Value #2 t Value
Yea d Net Cash d Net d Net Cash d Net
of $1 Year of $1
r Flow Cash Flow Flow Cash Flow
at 6% at 6%
1 $34,000 0.94340 $35,076 1 $34,000 0.94340 $32,076
2 32,000 0.89000 28,480 2 32,000 0.89000 28,480
3 26,000 0.83962 21,830 3 26,000 0.83962 21,830
4 32,000 0.79209 25,347 4 22,000 0.79209 17,426
4
(residual 10,000 0.79209 7,921
)
5 18,000 0.74725 13,451
6 12,000 0.70495 8,459
Total $124,000 $107,733 Total $124,000 $107,733
Cost (100,000) Cost (100,000)
NPV $7,733 NPV $7,733

Differential analysis is a useful planning tool for projecting relative results among
alternatives. It encourages managers to think ahead and analyze the components of alternative
outcomes with the goal of more insightful decision making.