*Originally published by Perform magazine.
Effective capital investment decisions underpin business success. The purchase of a new building, IT system or machine can enable a business to produce more of its goods and services so that it can expand and grow its market share. Depending on the nature of the investment, it may also enable the business to be quicker and more agile, and possibly cut its costs over the longer term. But while a wise investment can transform the prospects of a business, a poor investment can consume time, resources and money at a frightening rate, potentially threatening the business’s cash flow in the short term and even its viability in the long term. What’s more, any business that fails to deliver a healthy return on investment through its capital projects is likely to alienate its shareholders. So how can businesses go about the capital investment decision-making process in a way that increases their chances of success?
With capital investment, as with virtually every other project, it is essential for the business to get off to the right start if it is to minimise the risk that the investment fails to deliver on expectations at a later date. Hence strategy should be the starting point of any good capital investment decision-making process, according to David Tilston, a non- executive director and former CFO of several listed companies. He has had experience of making capital investment decisions relating to property, plant and equipment, as well as IT systems, throughout his career. “Any company is going to have finite financial resources,” he explains. “Therefore you want to try to direct the bulk of your investment towards areas that are consistent with your longer-term strategy.
“If you’re buying a property or making another type of large investment, typically you’re looking at it with a five- to ten-year time horizon, possibly longer. So the first question you ask should be: is this investment consistent with our strategy?”
Facts and figures
If the investment is consistent with the business’s strategy, the next step is to explore whether that investment is also sensible from an economic, financial and technical perspective. This is a big task, but there are various tools and techniques to assist with it, including cost-benefit analysis, cash flow forecasting and – for engineering-related projects – engineering economics.
“A capital budget or discounted cash flow analysis is generally considered the most useful way to think about the benefits of a project,” says Michael Goode, Solution Consultant at capital investment software provider Finario. “Done carefully, it can incorporate all the costs and benefits of an opportunity. Net present value (NPV) is the best return-on-investment (ROI) metric to measure a project’s absolute return, while profitability index (PI) should be used to rank a project’s relative return. With a discount rate that reflects your organisation’s cost of capital, the NPV of your project will give you a concrete measure of its value. PI will give you a simple, but highly accurate, way to compare returns across projects of different sizes. Both metrics should be estimated before budgeting, again at approval, and then during post-completion review…”