Evaluating Investment Projects — Financial and Non-Financial Factors
Financial Factors to Consider
When advising on a capital investment decision, consider:
- Compare payback and NPV — calculate both if not already done; interpret what the results mean
- Initial cost — how large is the outlay? Can the business afford it? How will it be funded (internally, borrowing, share issue)?
- Cash flows after payback — payback ignores these; the project with the longer payback may generate substantially more total cash
- Total cash generated over the life of the asset — a simple undiscounted sum of net inflows minus initial cost
- Life of the asset — does the asset last longer than the payback/NPV period? Are maintenance costs likely to rise in later years?
- Negative NPV — means the project does not earn the required rate of return at the given cost of capital; generally should not proceed on financial grounds
- Cost of capital sensitivity — if the cost of capital rises, NPV falls; a project with a marginally positive NPV is more risky
Non-Financial Factors to Consider
- Effect on staff — redundancies, retraining, morale, resistance to change
- Long-term capacity and demand — will demand continue to support the investment throughout the asset's life? Is the demand temporary or structural?
- Product quality — will the new asset improve or affect product quality?
- Opportunity cost — what else could the business do with the funds? (e.g. invest in marketing, another project, pay off debt)
- Risk and gearing — if financed by borrowing, does this increase financial risk? Effect on the business's ability to service debt
- Alternatives — e.g. leasing rather than buying; shorter-term contract; using existing equipment longer
- Environmental impact — carbon footprint, waste disposal, environmental regulations
- Reliability of estimates — cash flow forecasts may be inaccurate, especially in the long term; sensitivity analysis can test how sensitive NPV is to changes in assumptions
Reporting an Investment Decision
Capital investment appraisal decisions are often communicated in a formal report to management. A report typically includes:
- Introduction — purpose of the report
- Procedure — methods used (payback, NPV)
- Findings — results of calculations
- Conclusions — interpretation of results
- Recommendations — advised course of action with justification