Capital Analysis for Budgeting and Investments - Simply Finance

Capital analysis is the process of figuring out how much a capital expenditure and it's ensuing capital asset will cost and how much of a return it will generate. It also incorporates risk factors and helps to evaluate a proposed capital investment project.

For example, when a manufacturing company thinks about buying a new machine, capital analysis will tell you how much cash a proposed piece of equipment will produce for the company.

It's an important process because it tells you how much return you are getting on specific investments. It is also important because it will also tell you how much the entire capital investment will cost.

Capital analysis is used to find the best investments within a company.  You want to double down on your good investments and cut your losing ones.

In addition to projecting the cost and returns, capital analysis will also help you see how various risk factors will affect your investment.

Capital analysis is also a way to figure out the future value of a company. It will help you determine how the investment in capital will affect how much the company will be worth down the line.

So let's start out by defining some terms. A capital asset is usually a big and long-term investment that will cause the business to produce revenue over time. This would include fixed assets like land, buildings, equipment and other large investments.

A capital expenditure is money that is spent to buy or improve a capital asset. Other than building and equipment, other types of capital expenditures would include also include investments in new technologies, upgrades in buildings and equipment, acquisition of another company

Simply put, a capital expenditure is something that you spend money on that you don't process and sell on the market, but keep and will generate revenue for you long term, i.e. longer than one year.

One of the methods used in capital analysis is the discounted cash flow method of valuation. The discounted cash flow values a business based on future projected cash flows. It is then discounted by an interest rate.

This is done by figuring out the net present value or NPV. The NPV is a way of evaluating whether a capital expenditure will bring a rational rate of return.

The net present value is calculated by taking the sum of cash outflows, usually the capital expenditure, and the sum of cash inflows. Cash inflows would be the revenue that is generated from the capital asset that is purchased.

Then a discount rate is added which in capital analysis is usually called a hurdle rate.  It is called a hurdle rate because it is the minimum rate of return that is acceptable for a capital investment.

Here are some resources on learning how to do this process.  The first one is a course given by the Financial Management Training Center on capital analysis.  This will take you step by step and also has an exam at the end so you can make sure you have the principles down.

The next one is an article by Microsoft Office on performing capital budgeting analysis.  This is an overview of the entire process as well as some unique criticisms on the current models used.  It also has some links to helpful tools on Microsoft Office templates that will help you in this process.