This week’s reading covered how to analyze capital expenditures and how to outline a proposal for a new investment.
Capital expenditures are large projects that require a significant investment of cash. At the company I work at, we classify capital expenditures to be $5,000 or more. The three key concepts to analyze capital expenditures are future value, present value, and required rate of return.
Future value is what a given amount of cash will be worth if it’s loaned out or invested. For example, if I plan on giving money to an investor, I need to consider the percentage of earnings he can generate for me. If earnings were 2%, I’d be better off keeping my money in a bank since it offers a higher return and is a much safer investment. If earnings were 8%, I’d be much more likely to invest with him, even if more risk is associated.
Present value is the reverse of future value, as it is commonly used in evaluating investments in equipment, real estate, and M&A. To determine the present value, you must consider what kind of interest rate should be used to discount that future value.
The required rate of return is the rate people require before they will invest. It’s essential to consider the opportunity cost and cost of capital when making an investment. Interest rates and the stock market have an inverse relationship. When interest rates fall, people are more inclined to borrow money to purchase assets (stocks, cars, homes, etc.). When interest rates rise, people are less likely to borrow money since they have to pay more on interest, which gives bonds a higher return on investment.
When preparing a proposal for an investment, it is important to follow these steps.
(1) Collect all data about the investment costs (purchase price, shipping costs, taxes, installation, debugging, training, etc.). (2) Determine the benefits of the new investment. (3) Find out the company’s hurdle for this kind of investment by calculating the project’s net present value. (4) Calculate payback and internal rate of return.
Works Cited
Berman, Karen. “Financial Intelligence, Revised Edition: A Manager’s Guide to Knowing What the Numbers Really Mean.” Google Play, Google, Jan. 2013, https://play.google.com/books/reader?id=7TfCiz1LkMMC&pg=GBS.PR1&hl=en_US
Written by Mikael La Ferla
Mikael La Ferla 