Companies make capital investments to earn a return. This is like individuals wanting to make money when they invest in stocks and bonds. The amount of money made or lost is measured as the investment's rate of return. When making an investment, the expected rate of return is determined by the amount, timing, and riskiness of the funds expected from the investment.
RATE OF RETURN
An investment's rate of return is expressed as a percentage. For example, if a company invests $1,000 and expects to get back $1,100 one year from today, it expects to earn 10 percent (= (1,100 − 1,000)/1,000). If the company expects $1,200, it expects to earn 20 percent. So a rate of return depends first on the amount of money expected back from the investment.
Just as getting more money produces a higher rate of return, getting the money sooner also produces a higher rate of return. If a company earns 10 percent in six months, that is a higher rate of return than 10 percent earned in one year. So an investment's rate of return also depends on when the company expects to get the money back.
For most capital investments, the amount of money and/or the time at which the company expects to get it back are uncertain. What are the chances it will get exactly what it expects? What are the chances it will get more or less? What are the chances it will get a lot more or a lot less—or even lose all the money invested and get nothing back? The risk of the investment depends on these chances, and, in turn, how the investment's rate of return is calculated depends on this risk. So the third important dimension of an investment's rate of return is the risk connected with the amount of money a company expects to get back from the investment.
Time value of money
When a company evaluates a capital investment, the amount of money expected back from the investment is adjusted for its timing and risk. For example, suppose a company expects to get $100 one year from today. If it had that $100 now, it could invest the money—for example, earn interest from a bank—and have more than $100 next year. If the money earned 5 percent, the company would have $105 next year. If the process is reversed, the $100 the company expects to get next year is worth less than $100 today. At 5 percent interest, next year's $100 is worth only $95.24 (=$100/1.05) today. (This is because if the company had $95.24 now and earned 5 percent on the money, it would have $100 next year.) Similarly, if there is risk connected with the expected money—the company expects $100, but could get more or less—its value today is less than $95.24. Furthermore, the riskier it is, the lower its value today.
Typically, in order to make fair comparisons, the value of all of the amounts of money expected back from capital investments are converted into what are called present values. The rate of return used to calculate the present value for a capital investment is called the cost of capital. The cost of capital is the minimum rate of return the company must earn to be willing to make the investment. It is the rate of return the company could earn if, rather than making the capital investment, it invested the money in an alternative, but comparable, investment. The cost of capital exactly reflects the riskiness of the money expected back from the capital investment. The mathematical methods used to calculate present values are called the time value of money and are explained in more detail in the books in the bibliography.
Net present value (NPV)
A capital investment's net present value (NPV) is the amount of value the company expects the investment to create. The NPV equals the sum of the present values of all of the money expected back from the investment minus the investment's cost.
MAKING CAPITAL INVESTMENTS
The capital investment process includes the following:
- Generating ideas for capital investments
- Classifying capital investments
- Evaluating and choosing proposed capital investments
The first, and most important, part of the capital investment process is generating new ideas. Ideas for capital investments can originate anywhere in a company. Often plant managers are responsible for identifying potential projects that will enable their plants to operate on a different scale or on a more efficient basis. For instance, a plant manager might suggest adding 10,000 square feet of production space to a plant or replacing a piece of equipment with a newer, more efficient machine. Ideas for better types of equipment that can help the company operate more efficiently may come from individuals on the plant floor. After screening out undesirable ideas, managers send the ones that appear to be attractive to the divisional level, with supporting documentation.
Division management not only reviews such proposals but also adds ideas of its own. For example, division management may propose the introduction of a new product line. Alternatively, management may want to combine two plants and eliminate the less efficient one. Such ideas are less likely to come from the plant managers!
This bottom-up process results in ideas percolating upward through the organization. At each level, ideas submitted by lower-level managers are screened, and attractive ones are forwarded to the next level. In addition, managers at successively higher levels, who are in a position to take a broader view of the company's business, add ideas that may not be visible, or desirable, to lower-level managers.
At the same time, there is also a top-down process at work in most companies. Strategic planners will generate ideas regarding new businesses the company should enter, other companies it might acquire, and ways to modify its existing businesses to achieve greater profitability. Strategic planning is a critical element in the capital investment process. The processes complement one another. The top-down process generates ideas of a broader, more strategic nature, whereas the bottom-up process generates ideas of a more project-specific nature.
In addition, many companies have a research and development (R&D) group, either within a production division or as a separate department. An R&D group often provides new ideas for products that can be sent on to a marketing research department.
Classifying Capital Investments
Analysis costs money. Therefore, certain types of investments receive only cursory checks before approval, whereas others are subjected to extensive analysis. Generally, less costly and more routine investments are subjected to less extensive evaluation. As a result, companies typically categorize investments and analyze them at the level judged appropriate to their category. Potential investments in each category may have a lot in common and are able to be analyzed similarly. A useful set of investment classifications is:
Capacity expansions in current businesses
New products and new businesses
Projects required by government regulation or company policy
At the most basic level, a company must make certain investments to continue to be a healthy, profitable business. Replacing worn-out or damaged equipment is necessary to continue in business. Therefore, the major questions concerning such investments are "Should we continue in this business?" and if so, "Should we continue to use the same production process?" Since the answers to these questions are so frequently yes, an elaborate decision-making process is not needed, and typically such decisions are approved with only routine review.
Cost savings/revenue enhancement
Projects in this class include improvements in production technology to realize cost savings and marketing campaigns to achieve revenue enhancement. The central issue is increasing the difference between revenue and cost; the result must be sufficient to justify the investment.
Capacity expansion in current businesses
Deciding to expand the current business is inherently more difficult than approving maintenance or cost-saving proposals. Firms have to consider the economics of expanding or adding new facilities. They must also prepare demand forecasts, keeping in mind competitors' likely strategies. Marketing consultants may help, but this class of projects naturally has more uncertain return projections than do maintenance or replacement projects.
New products and new businesses
Projects in this category, which include R&D activities, are among the most difficult to evaluate. Their newness and long lead times make it very difficult to forecast product demand accurately. In many cases, the project may be of special interest because it would give the company an option to break into a new market. For example, a company that has a proprietary technology might spend additional R&D funds trying to develop new products based on this technology. If successful, these new products could pave the way for future profitable investment opportunities. Access to such opportunities represents valuable options for the company.
Meeting regulatory and policy requirements
Government regulations and/or company policies concerning such things as pollution control and health or safety factors are viewed as costs. Often, the critical issue in such projects is meeting the standards in the most efficient manner and at the minimum cost.
The typical stages for the development and approval of a capital investment proposal are:
- Approve funds for research that may result in a product idea.
- Approve funds for market research that may result in a product proposal.
- Approve funds for product development that may result in a usable product.
- Approve funds for plant and/or equipment for the production and sale of the new product.
Each stage involves an investment decision at one or more levels of the company. At each stage, the company re-estimates the value expected to be created—the NPV—of going ahead. With this kind of sequential appropriation of funds, an automatic progress review is enforced, enabling early cancellation of unsuccessful projects. At each stage there are options to abandon, postpone, change, or continue.
Proposed expenditures that are larger than certain company-set limits generally require a written proposal from the initiator. Typically, such limits are higher in smaller privately owned companies, which tend to have relatively informal organizational structures. Most companies use standard forms, and these are often supplemented by written memoranda for larger, more complex projects. Also, there may be consulting or other studies prepared by outside experts; for example, economic forecasts from economic consultants.
For a successful company, a maintenance project might require only limited supporting information. In contrast, a new product would require extensive information gathering and analysis. At the same time, within a category, managers at each level usually have upper limits on their authority regarding both expenditures on individual assets and the total expenditure for a budgeting period. In this way, larger projects require the approval of higher authority.
For example, at the lowest level, a department head may have the authority to approve $50,000 in total equipment purchases for the year. However, that same person might have to obtain specific approval from higher authority to spend more than $10,000 for any single piece of equipment. A plant manager might have authorization limits of $500,000 per year and $100,000 per piece of equipment, for example.
A system of authorization, such as illustrated in the preceding paragraph, requires more extensive review and a greater number of inputs to approve larger expenditures. The hierarchical review structure reflects the obvious fact that misjudging a larger project is potentially more costly than misjudging a smaller one.
CAPITAL INVESTMENT IN OTHER COMPANIES
Sometimes companies make capital investments in other companies. In concept, these are just like any other capital investment. They range from the simple, such as buying stock in another company in a passive investment, to acquiring, or purchasing, another company outright or merging with another company. With an acquisition or merger, the details connected with such things as taxes, corporate cultures, distribution of responsibilities, and logistics, among others, can be exceedingly complex.
Companies give many different reasons for acquisition or merger. In most cases, they want to achieve operating efficiencies and/or economies of scale. For example, in a merger the companies may be able to save money marketing, producing, and delivering their products by combining their operations and eliminating duplication. Combining may also allow greater efficiency in coordinating activities across the companies' units.
A company may be able to expand more cheaply and more quickly through an acquisition or merger. There are also other possible reasons, such as realizing tax benefits and capturing surplus cash. The essence of all the possible reasons is a belief that the merger or acquisition is a good capital investment. Therefore, the analytical tools and basic decision rules are the same for mergers and acquisitions as they are for other capital investments. However, particular care must be taken in applying these tools because of the enormous size and complexity of the investment.
Beyond the basic investment considerations, there can also be important legal considerations connected with a merger or acquisition. These include aspects such as compliance with federal antitrust laws, state anti-takeover statutes, financial securities laws, and the charters of the corporations involved.
see also Finance; Time Value of Money
Brealey, Richard A., Meyers, Stewart C., and Marcus, Alan J. (2007). Fundamentals of Corporate Finance (5th ed.). Boston: McGraw-Hill/Irwin.
Emery, Douglas R., Finnerty, John D., and Stowe, John D. (1998). Principles of Financial Management. Upper Saddle River, NJ: Prentice-Hall.
Ross, Stephen A., Westerfield, Randolph W., and Jordan, Bradford D. (2006). Fundamentals of Corporate Finance. Boston: McGraw-Hill/Irwin.
Douglas R. Emery
John D. Finnerty