Capital Investments
| Author | Douglas Emery, John Finnerty |
| Pages | 71-74 |
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Companies make capital investments to earn a return. This is like individuals wanting to make money when they invest in stocks and bonds. The amount of money made or lost is measured as the investment's rate of return. When making an investment, the expected rate of return is determined by the amount, timing, and riskiness of the funds expected from the investment.
An investment's rate of return is expressed as a percentage. For example, if a company invests $1,000 and expects to get back $1,100 one year from today, it expects to earn 10 percent (= (1,100 − 1,000)/1,000). If the company expects $1,200, it expects to earn 20 percent. So a rate of return depends first on the amount of money expected back from the investment.
Just as getting more money produces a higher rate of return, getting the money sooner also produces a higher rate of return. If a company earns 10 percent in six months, that is a higher rate of return than 10 percent earned in one year. So an investment's rate of return also depends on when the company expects to get the money back.
For most capital investments, the amount of money and/or the time at which the company expects to get it back are uncertain. What are the chances it will get exactly what it expects? What are the chances it will get more or less? What are the chances it will get a lot more or a lot less—or even lose all the money invested and get nothing back? The risk of the investment depends on these chances, and, in turn, how the investment's rate of return is calculated depends on this risk. So the third important dimension of an investment's rate of return is the risk connected with the amount of money a company expects to get back from the investment.
When a company evaluates a capital investment, the amount of money expected back from the investment is adjusted for its timing and risk. For example, suppose a company expects to get $100 one year from today. If it had that $100 now, it could invest the money—for example, earn interest from a bank—and have more than $100 next year. If the money earned 5 percent, the company would have $105 next year. If the process is reversed, the $100 the company expects to get next year is worth less than $100 today. At 5 percent interest, next year's $100 is worth only $95.24 (=$100/1.05) today. (This is because if the company had $95.24 now and earned 5 percent on the money, it would have $100
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next year.) Similarly, if there is risk connected with the expected money—the company expects $100, but could get more or less—its value today is less than $95.24. Furthermore, the riskier it is, the lower its value today.
Typically, in order to make fair comparisons, the value of all of the amounts of money expected back from capital investments are converted into what are called present values. The rate of return used to calculate the present value for a capital investment is called the cost of capital. The cost of capital is the minimum rate of return the company must earn to be willing to make the investment. It is the rate of return the company could earn if, rather than making the capital investment, it invested the money in an alternative, but comparable, investment. The cost of capital exactly reflects the riskiness of the money expected back from the capital investment. The mathematical methods used to calculate present values are called the time value of money and are explained in more detail in the books in the bibliography.
A capital investment's net present value (NPV) is the amount of value the company expects...
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