What are some of the methods for evaluating capital expenditures?

Definition of Evaluating Capital Expenditures

Capital expenditures involve large amounts of money spent on assets that have a useful life of more than one year.

Capital expenditures may vary in necessity and profitability:

  • Some capital expenditure projects are required and may not increase a company's profits...think OSHA or environmental mandates
  • Some of projects will provide cost savings through faster operations or reductions in manual labor
  • Other capital expenditures allow for product enhancements, additional quality, etc. for which the company will obtain higher revenues from its customers

Since companies generally have limited amounts of money and employees to implement new projects as well as limits to the amount of disruptions to their existing operations, the potential projects are rank/prioritized through a process known as capital budgeting.

Examples of Methods for Evaluating Capital Expenditures

Of course, capital expenditures that are necessary to continue operating are identified first. These could be government mandates as well as other necessities such as a new sewer line, upgrading the electrical service, etc.

When deciding which of the non-necessary projects should be undertaken, companies likely use various techniques for ranking the projects from a financial point of view. The following are four common techniques:

  • Payback calculates the number of years it will take to recoup the cash spent on a project. There are two weaknesses with the payback method: 1) the time value of money is not considered, and 2) the cash flows occurring after the cash is paid back is ignored.
  • Accounting rate of return or return on investment divides the increase in accounting profit by the amount of the increased investment. This technique also ignores the time value of money.
  • Internal rate of return considers both the time value of money and cash flows occurring throughout the entire life of the project. The internal rate of return technique computes the interest rate that will discount the future cash flows so that the present value of those cash flows is equal to the cash outlay for the project.
  • Net present value discounts the project's future cash flows by a predetermined rate, such as the rate needed or the targeted rate. If the present value of the cash flows (resulting from the discounting by the targeted rate) exceeds the amount of the cash investment, the project is accepted since it provides the required return (or more).