Chapter 3. Evaluating Capital Investments
One of the most common financial analysis tasks with which a controller is confronted is evaluating capital investments. In some industries, the amount of money poured into capital improvements is a very substantial proportion of sales, and so is worthy of a great deal of analysis to ensure that a company is investing its cash wisely in internal improvements. This section reviews the concept of the hurdle rate, as well as the three most common approaches for evaluating capital investments. It concludes with reviews of the capital investment proposal form and the postcompletion project analysis, which brings to a close the complete cycle of evaluating a capital project over the entire course of its acquisition, installation, and operation.
When controllers are given capital investment proposal forms to review, they need some basis on which to conduct the evaluation. What makes a good capital investment? Is it the project with the largest net cash flow, the one that uses the least capital, or some other standard of measure?
The standard criterion for investment is the hurdle rate—the discounting rate at which all of a company’s investments must exhibit a positive cash flow. It is called a hurdle rate because the summary of all cash flows must exceed, or hurdle, this rate, or else the underlying investments will not be approved. The use of a discount rate is extremely important, for it reduces the value of cash inflows and outflows ...