Capital Investment Analysis
Capital investments (think: that new billion dollar battery factory) cost big bucks. So before writing that check, a detailed investment analysis needs to be done to be sure the dough isn't...wasted.
The capital analysis needs to predict whether or not the asset will produce earnings that exceed the cost of the asset. That's the basic magic flint that lights the light that turns green when the profits from that investment exceed the cost of doing it.
For example, if a cookie producer buys an automated machine that can produce 5,000 more cookies a day, will the earnings contributed from those incremental cookies exceed the $400,000 cost of the machine? And how long will it take to get the, uh...dough back?
Pro investors usually use techniques such as a net present value analysis or discounted cash flow. Since today’s money has more buying power than tomorrow’s, net present value is the difference between the present value of cash inflows (how many more cookies the company will sell) and the present value of cash outflows (the cost of the machine) over a specific period of time.
In other words, a positive net present value predicts that the earnings generated by the new machine exceed the costs. If the net present value is positive, the investment should be profitable. But if the investment has a negative net present value, it will probably result in a net loss. So...if the machine won’t pay for itself within three years, the project may not be approved.
It’s always wise to remember the garbage in, garbage out rule, i.e. the analysis is only as good as the numbers you enter. If you are too optimistic about future sales, for example, your net present value may not be accurate.
Related or Semi-related Video
Finance: What Does "Capital Intensive" M...27 Views
Finance a la shmoop what does capital-intensive mean? lots and lots and
lots and lots of capital yeah that's what it means starting a website, two [Two young kids setting up a website in a garage]
kids a garage and a nice home computer not capital intensive, drilling for oil
in the North Sea highly capital intensive...
well capital needed for the two kids in a garage building a search engine about
two million bucks capital needed for the oil rig well like ten billion bucks and
why does the capital intensity matter well if you can create Google that
generates a few billion dollars of free cash flow a quarter for a total capital
input of maybe a hundred million dollars ie a few rounds after the garage round [Equity investment agreement documents appear]
then investors in it make an absolute killing like if you don't dilute
yourselves and the stock goes up a lot life's good yeah hundreds or thousands
of times their original investment if you create BP British Petroleum or Royal
Dutch Shell or Chevron which also have a few billion dollars of free cash flow a [Cash flowing into fuel tanks]
quarter but it takes you ten billion dollars in capital to generate those
returns then yes you get a nice investment return but it's nothing that
you know Vikings sing songs about and it's the allure of the capital [Man typing on laptop]
unintensive businesses like building a website in Yahoo or a search engine in Google or a video streaming
site in Netflix that takes relatively small amounts of capital to start and
then produces mounds of free cash profits that has made venture
capitalists fall all over themselves hoping to find that one little garage [Person looking through binoculars at garages]
with the next great white whale yeah that's intensive...