Capital Investment Analysis and Project Assessment
Michael Boehlje and Cole Ehmke Department of Agricultural Economics
Capital investment decisions that involve the purchase of items such as land, machinery, buildings, or equipment are among the most important decisions undertaken by the business manager. These decisions typically involve the commitment of large sums of money, and they will affect the business over a number of years. Furthermore, the funds to purchase a capital item must be paid out immediately, whereas the income or benefits accrue over time. Because the benefits are based on future events and the ability to foresee the future is imperfect, you should make a considerable effort to evaluate investment alternatives as thoroughly as possible. The most important task of investment analysis is gathering the appropriate data. The procedures discussed in this publication teach you how to evaluate the decision, but if you have inaccurate or incomplete data, then an otherwise thorough and complete analysis will be misleading. Selecting investments that will improve the financial performance of the business involves two fundamental tasks: 1) economic profitability analysis and 2) financial feasibility analysis. Economic profitability will show if an alternative is economically profitable. However, an investment may not be financially feasible: that is, the cash flows may be insufficient to make the required principal and interest payments. So you should complete both analyses before you make a final decision to accept or reject a particular project. This publication discusses both of these tasks. (Much of the discussion is abstracted from Boehlje, M. D. and V. R. Eidman. Farm Management, Wiley, 1986, Chapter 8.)
Audience: Business managers facing a capital investment decision Content: Presents two phases of project assessment: economic profitability and financial feasibility Outcome: Readers will be familiar with the time value of money and be able to calculate the net present value of a project and determine if the investment will generate enough cash to make debt payments
Completing a thorough investment analysis may seem complicated and difficult. But the reward of a soundly based decision will be worth the effort invested to learn the process and collect the necessary information. To help, this publication follows an example through the economic profitability and financial feasibility analysis process. In addition, an appendix contains the figures used to determine the present value of money received in the future.
The purpose of an economic profitability analysis is to determine whether the investment will contribute to the longrun profits of the business. Although various techniques can be used to evaluate alternative investments, including the payback period and internal rate of return, the most
commonly accepted technique is net present value, otherwise known as “discounted cash flow.”
Time Value of Money
The basic concept of a net present value procedure is that a dollar in hand today is worth more than a dollar to be received sometime in the future. A dollar is worth more today than tomorrow because today’s dollar can be invested and can generate earnings. In addition, the uncertainty of receiving a dollar in the future and inflation make a future dollar less valuable than if it were received today. The procedure for accounting for the delay in receiving funds or the income given up is to discount, or penalize, future cash flows. The longer you must wait to receive them, the more heavily you must discount them. This discounting procedure converts the cash flows that occur over a period of future years into a single current value so that alternative investments can be compared on the basis of that single value. This conversion of flows over time into a single figure via the discounting procedure takes into account the opportunity cost...