Method of Evaluating Capital Investment Proposals
Capital Investment is the money that the company uses to purchase a fixed asset such as land, building, and machinery rather than daily operation. The company expects to generate a return from such investment.
The company invests more capital to expand the operation, create new products, and increase production. Sometimes, new investment also helps to reduce costs by moving from manual to automatic work such as machinery or AI. Another reason is to replace the existing asset which reaches their lives or broken.
Due to the limitation of the fund, the company needs to evaluate each investment proposal before accept or reject the project.
Method of evaluating:
These are the four methods which use to evaluate the capital investment proposals:
- The average rate of return method
- The payback period method
- The net present value method
- The internal rate of return method.
The average rate of return method
ARR is the rate of return which the company expects to get from the capital investment. It ignores the time value of money by not calculating the present value. ARR divide the annual return with the initial investment.
The payback period method
The payback period is the time spend to receive the initial investment, the shorter the better. It the time which the project reaches the Break-event point. The cash inflow which uses in this method do not discount the present value, so it completely ignores the time value of money.
The net present value method
Different from the two methods above, NPV base on the time value of money to evaluate each capital investment. It is the initial investment less all present value of all expected future cash flow.
The internal rate of return method
IRR is the financial ratio which use to estimate the profitability of the investment project. It is the rate that makes NPV equal to zero in discount cash flow analysis.