Whether you’re buying equipment, automating processes, launching a new product line or expanding your facilities, capital investment decisions shouldn’t be based on intuition alone. Your management team may identify several promising growth opportunities. Which ones can your business realistically support today with available cash flow, financing and staffing, and which ones can wait?

A comprehensive financial analysis can help you compare alternatives and allocate resources where they’ll likely have the greatest long-term benefit.

Develop financial projections

Start by evaluating how a proposed investment is likely to affect your business’s financial results. Historical financial statements typically serve as a baseline for financial projections.

Use your most recent income statement to develop realistic assumptions about 1) how much additional revenue (or cost savings) the project is expected to generate, and 2) what incremental expenses it will incur. In some cases, qualifying property may be eligible for special tax savings, such as 100% bonus depreciation or Section 179 expensing, that should be factored into the decision.

A proposed investment may also affect your balance sheet and statement of cash flows. For example, a project may require additional working capital and fixed assets. Preparing comprehensive financial projections helps you determine how much cash the project will need each period and whether internal resources will be sufficient to finance it. Some projects will require the business to tap its line of credit or obtain additional loans or capital contributions.

Financial projections are only as reliable as their underlying assumptions. So consider how the projected results would change if implementation is delayed, costs exceed estimates or expected cash flows fall short. Comparing best-case, worst-case and most-likely scenarios can reveal which assumptions pose the greatest risk to the investment.

Evaluate competing opportunities

Once you’ve estimated the projected cash flows, it’s time to analyze the results and prioritize competing investment alternatives. For example, you might have $50,000 to invest in either a new machine or IT upgrades. Which option is better from a financial perspective?

Three common financial tools for evaluating such decisions are:

1. Payback period. This tells you how long it will take for a project to recoup its initial investment without considering the time value of money. For example, suppose a new machine that costs $48,000 is expected to generate $12,000 of incremental cash flow annually. Its payback period would be four years ($48,000 / $12,000).
2. Net present value (NPV). When calculating NPV, you discount each period’s projected cash flow to its present value. The sum of the present values for all the periods, including the cost of the initial investment, equals the project’s NPV. If NPV is greater than zero, the project is expected to create value and generally warrants further consideration. If not, the project may not be worthwhile. Typically, management uses the business’s cost of capital or a discount rate that reflects the project’s risk profile to discount projected cash flows.
3. Internal rate of return (IRR). This is the discount rate at which a project’s NPV equals zero. Management typically has a preset hurdle rate that a project must exceed to be considered. For example, if management sets its hurdle rate at 15%, any project with an IRR below 15% will be less likely to move forward.

When applying these financial tools, it’s also important to consider qualitative factors. For example, IT upgrades might strengthen cybersecurity, improve efficiency, enhance customer service and reduce business risk — benefits that may be difficult to quantify in financial projections.

Need help?

Strong investment decisions combine sound financial analysis with strategic objectives, operational considerations and risk management. Contact us to help you evaluate potential capital investment projects and identify which opportunities make the best use of your business’s resources.

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