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PURDUE EXTENSION

EC-731

Capital Investment Analysis and Project Assessment

Michael Boehlje and Cole Ehmke Department of Agricultural Economics

Capital investment decisions that involve the purchase of items such as land, machinery, buildings, or equipment are among the most important decisions undertaken by the business manager. These decisions typically involve the commitment of large sums of money, and they will affect the business over a number of years. Furthermore, the funds to purchase a capital item must be paid out immediately, whereas the income or benefits accrue over time.

Because the benefits are based on future events and the ability to foresee the future is imperfect, you should make a consider- able effort to evaluate investment alternatives as thoroughly as possible. The most important task of investment analysis is gathering the appropriate data. The procedures discussed in this publication teach you how to evaluate the decision, but if you have inaccurate or incomplete data, then an otherwise thorough and complete analysis will be misleading.

Selecting investments that will improve the financial perfor- mance of the business involves two fundamental tasks: 1) economic profitability analysis and 2) financial feasibility analysis. Economic profitability will show if an alternative is economically profitable. However, an investment may not be financially feasible: that is, the cash flows may be insufficient to make the required principal and interest payments. So you should complete both analyses before you make a final decision to accept or reject a particular project. This publica- tion discusses both of these tasks. (Much of the discussion is abstracted from Boehlje, M. D. and V. R. Eidman. Farm Management, Wiley, 1986, Chapter 8.)

Audience: Business managers facing a capital investment decision

Content: Presents two phases of project assessment: economic profitability and financial feasibility

Outcome: Readers will be familiar with the time value of money and be able to calculate the net present value of a project and determine if the investment will generate enough cash to make debt payments

Completing a thorough investment analysis may seem complicated and difficult. But the reward of a soundly based decision will be worth the effort invested to learn the process and collect the necessary information. To help, this publica- tion follows an example through the economic profitability and financial feasibility analysis process. In addition, an appendix contains the figures used to determine the present value of money received in the future.

Economic Profitability

The purpose of an economic profitability analysis is to determine whether the investment will contribute to the long- run profits of the business. Although various techniques can be used to evaluate alternative investments, including the payback period and internal rate of return, the most

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