Capital Investment Decisions – Process

Effective capital investment decisions must allocate constrained resources (cash) to projects that will return a positive cash flow over a time horizon dictated by an owner or by corporate policy.  You might hear the term hurdle rate used by your financial department or banker.  The hurdle rate is the minimum rate that your company expects to earn when investing in a project. The hurdle rate is also referred to as the company’s required rate of return (ROI) or target rate. Typically a project’s internal rate of return must equal or exceed the hurdle rate.  When there are multiple demands for cash for example, a new marketing campaign, geographic expansion plans, a need for additional production capacity, replacement of outdated or high maintenance equipment, each project will be prioritized depending on the cash they generate over a predetermined time frame.  The time frame will play an important role if the company is currently focused on projects that provide prompt returns versus projects which will contribute to future growth.  The factors below will influence capital investment decisions:

  • Management’s outlook (positive or negative)
  • Opportunities due to technological improvements
  • What the competitor is doing
  • Changing customer requirements
  • Cash flow budget
  • Economic forecast
  • Other non-financial factors

You want to avoid reaching a capital investment decision subjectively then apply financial metrics in an attempt to rationalize the decision.  As I referred to in a previous discussion, internal politics can play a role in subjective decisions when individuals or groups have a personal interest in certain projects.  The capital investment process usually involves the following seven steps:

  • Project identification
  • Project definition
  • Analyze the project benefits (financial and non-financial)
  • Approve capital investment
  • Implement the project
  • Project management
  • Audit and report actual benefits versus assumptions

I will dig deeper into each of these steps in my future discussions.  As I discuss each step I will post user friendly templates on our website that can help improve your capital investment decision process.

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