A Step-By-Step Guide to Analysing Capital Expenditures

You’ve been talking with your boss about buying a new piece of equipment for the plant, or maybe mounting a new marketing campaign. He ends the meeting abruptly. “Sounds good”, he says. “Write me up a proposal with the ROI and have it on my desk by Monday”.

Don’t panic, here’s a step-by-step guide to preparing your proposal.

A.     Remember that ROI means “return on investment” – just another way of saying, “Prepare an analysis of this capital expenditure”. The boss wants to know whether the investment is worth it, and he wants calculations to back it up.

B.     Collect all the data you can about the cost of the investment. In the case of a new machine, total costs would include the purchase price, shipping costs, installation, factory downtime (while installation occurs), debugging, and so on. Where you must make estimates, note that fact. Treat the total as your initial cash outlay. You will also need to determine the machine’s useful life, not an easy task (but part of the art I enjoy so much!) You might talk to the manufacturer and to others who have purchased the equipment to help you answer the question.

C.     Determine the benefits of the new investment, in terms of what it will save the company or what it will help the company to earn. A calculation for a new machine should include any cost savings from greater output speed, less rework, a reduction in the number of people required to operate the equipment, increased sales because customers are happier, and so on. The tricky part here is that you need to figure out how all these factors translate into an estimate of cash flow. Don’t be afraid to ask for help from your finance department – they are trained in this kind of thing and should be willing to help.

D.    Find out the company’s hurdle rate (remember, this is the interest rate you will use to discount the future cash flows) for this kind of investment. Calculate the net present value of the project using this hurdle rate.

E.     Calculate payback and internal rate of return as well. You’ll probably get questions about what they are from your boss, so you need to have the answers ready.

F.     Write up the proposal. Keep it brief. Describe the project, outline the costs and benefits (both financial and otherwise), and describe the risks. Discuss how it fits with the company’s strategy or competitive situation. Then give your recommendations. Include your NPV, payback, and IRR calculation in case there are questions about how you arrived at your results.

Managers sometimes go overboard in writing up capital expenditure proposals. It’s probably human nature: we all like new things, and it’s usually pretty easy to make the numbers turn out so that the investment looks good. But I advise conservatism and caution. Explain exactly where you think the estimates are good and where you think they may be shaky. Do a sensitivity analysis, and show (if you can) that the estimate makes sense even if cash flows don’t materialise at quite the level you hope. A conservative proposal is one that is likely to be funded – and one that is likely to add the most to the company’s value in the long run.