11.1 Describe Capital Investment Decisions and How They Are Applied

Capital investment decisions are crucial for a company's long-term success. These choices involve allocating resources to projects that promise future benefits. The five-step process guides managers through identifying opportunities, gathering data, making predictions, and evaluating outcomes.

Understanding the difference between capital expenditures and operating expenses is key. CAPEX focuses on long-term assets, while OPEX covers day-to-day costs. Evaluating investment alternatives involves screening projects and making preference decisions using techniques like NPV, IRR, and payback period.

Capital Investment Decisions

Five-step capital investment process

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1. Identify potential investments involves determining available capital and potential projects that align with the company's strategy and goals (expanding production capacity, entering new markets)
2. Obtain information by gathering relevant data for each potential investment, estimating cash inflows and outflows, and determining the project's expected life and salvage value (useful life of equipment, resale value of assets)
3. Make predictions by forecasting future cash flows based on obtained information, considering risk and uncertainty, and using sensitivity analysis to assess the impact of changes in key variables (sales volume, raw material costs)
4. Make decisions by evaluating projects using capital budgeting techniques (NPV, IRR, payback period), comparing projects, selecting the most profitable option(s), and considering non-financial factors (environmental impact, employee morale)
   • Consider the opportunity cost of each investment option
5. Implement and evaluate the selected project(s), monitor progress, compare actual results to predictions, make adjustments as needed, and learn from the experience (post-implementation review, lessons learned)

Capital expenditures vs operating expenses

• Capital expenditures (CAPEX) use funds to acquire or upgrade long-term assets (equipment, buildings, software), are recorded as assets on the balance sheet, depreciated over time, and aim to generate long-term benefits and increase production capacity
• Operating expenses (OPEX) are day-to-day costs incurred to maintain business operations (salaries, rent, utilities), are recorded on the income statement in the period they are incurred, and are necessary for maintaining current production levels and business functions

Evaluation of investment alternatives

• Screening decisions determine which projects meet the company's minimum requirements for profitability (minimum rate of return), risk (acceptable risk level), and strategic fit (alignment with company goals and objectives), eliminating projects that do not meet the criteria
  • This process often involves setting a hurdle rate for project acceptance
• Preference decisions rank and select projects that have passed the screening process using capital budgeting techniques:
  • Net Present Value (NPV) calculates the present value of a project's future cash flows using the formula $NPV = \sum_{t=0}^{n} \frac{CF_t}{(1+r)^t} - Initial Investment$, with projects having positive NPV being preferred
  • Internal Rate of Return (IRR) calculates the discount rate that makes a project's NPV equal to zero using the formula $0 = \sum_{t=0}^{n} \frac{CF_t}{(1+IRR)^t} - Initial Investment$, with projects having IRR higher than the required rate of return being preferred
  • Payback period calculates the time required to recover the initial investment using the formula $Payback Period = \frac{Initial Investment}{Annual Cash Inflow}$, with projects having shorter payback periods being preferred
• Projects are selected based on rankings until the capital budget is exhausted or no more profitable projects remain

Advanced Considerations in Capital Investment Decisions

• Time value of money: Recognizes that a dollar today is worth more than a dollar in the future, influencing project valuation
• Discounted cash flow analysis: Incorporates the time value of money to evaluate long-term projects more accurately
• Risk assessment: Evaluates potential uncertainties and their impact on project outcomes
• Capital rationing: Addresses situations where a company has limited funds and must choose between multiple profitable investment opportunities