Putting It Together: Capital Investment Analysis

Let’s revisit South Side Brewery and the stage for the musicians’ project. Recall that the company expects revenue to increase by $6,000 per month because of increased alcohol sales and expenses (cost of the bands) to increase by $4,000 per month. Therefore, net cash inflows are projected to be $24,000 per year for the life of the project. The cost to build the stage with a lighting and sound system is $120,000. It will be good for at least eight years.

We already know that the simple payback period will be five years (5 * $24,000 = $120,000).

1. What is the Internal Rate of Return?

Using Excel, we find that the IRR is 11.815%.

2. What is the NPV if we use a 10% WACC/hurdle rate?

Description Amount Factor Total
Year 1 $       24,000           0.9090 $    21,816
Year 2           24,000           0.8260 $    19,824
Year 3           24,000           0.7510 $    18,024
Year 4           24,000           0.6830 $    16,392
Year 5             24,000           0.6210 $    14,904
Year 6             24,000           0.5640 $    13,536
Year 7           24,000           0.5130 $    12,312
Year 6             24,000           0.4670 $    11,208
Total present value of cash inflows Single Line$   128,016
Initial investment $ (120,000)
Net present value of project Single Line$     8,016Double line

 

What is the NPV at 10% if we use an annuity table since all of the cash flows are equal?

Present Value of Ordinary Annuity of $1
Periods 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 12% 14% 15% 16% 18% 20%
Period 1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 0.893 0.877 0.870 0.862 0.847 0.833
Period 2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736 1.690 1.647 1.626 1.605 1.566 1.528
Period 3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487 2.402 2.322 2.283 2.246 2.174 2.106
Period 4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170 3.037 2.914 2.855 2.798 2.690 2.589
Period 5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791 3.605 3.433 3.352 3.274 3.127 2.991
Period 6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355 4.111 3.889 3.784 3.685 3.489 3.326
Period 7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868 4.564 4.288 4.160 4.039 3.812 3.605
Period 8 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335 4.968 4.639 4.487 4.344 4.078 3.837
Period 9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759 5.328 4.946 4.772 4.607 4.303 4.031
Period 10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145 5.650 5.216 5.019 4.833 4.494 4.192
Period 11 10.368 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.495 5.938 5.453 5.234 5.029 4.656 4.327
Period 12 11.255 10.575 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814 6.194 5.660 5.421 5.197 4.793 4.439
Period 13 12.134 11.348 10.635 9.986 9.394 8.853 8.358 7.904 7.487 7.103 6.424 5.842 5.583 5.342 4.910 4.533
Period 14 13.004 12.106 11.296 10.563 9.899 9.295 8.745 8.244 7.786 7.367 6.628 6.002 5.724 5.468 5.008 4.611

$24,000 * 5.335 = $128,040 (slightly different than the $128,016 in the prior calculation due to rounding of the factor).

And the profitability index?

128/120 = 1.07. Slightly above 1.0, so an acceptable (although not fantastic) investment.

There is no singular “right” way to make a capital decision, and remember that there will always be qualitative factors at play. For instance, a college campus may charge fees for a parking structure, but they may not cover costs, resulting in an IRR less than the normal hurdle rate or even a negative cash flow, but the project may be approved anyway because it contributes to the larger plan of increasing enrollment and handling the increased capacity. In addition, there may be emergency projects, such as replacing a machine that unexpectedly broke down, that do not go through the normal process and analysis.

However, for most projects, the process should resemble the process laid out in this module:

Phase 1 – Screening

  1. Begin with the larger picture
  2. Identify and evaluate potential opportunities
  3. Screen opportunities

Phase 2 – Analysis

  1. Estimate operating and implementation costs
  2. Estimate cash flow
  3. Assessment

Phase 3 – Implementation

  1. Select the project
  2. Implement the project
  3. Re-evaluate the decision

It is important to remember, too, that part of Phase 3 – Implementation is to review the actual results in order to gather information for subsequent projects. How close were the projected cash flows? (It’s human nature to overestimate revenues and underestimate expenses.) What costs were omitted? (Often, the effect of a capital project on the operating budget is overlooked or underestimated.) What parts of the decision-making process went smoothly, and what parts were overly difficult? These and a host of other questions inform and improve the process. An evaluation also holds managers accountable for projected results and provides feedback on how the project is going.

Finally, here is a brief summary of how to use differential analysis to present alternatives to management.

You can view the transcript for “Differential Analysis – Concepts” here (opens in new window).