When determining a good investment, how should you proceed to get management's approval?

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Answered by: Paul, An Expert in the Financial Analysis Category
Any company, large or small, should evaluate a capital investment before making the expenditure. "Determining a good investment" requires the evaluation of several factors. What effect will the new investment have on sales and costs? What is its economic life and how will it be depreciated? What are the tax consequences of making the investment and what is its cost? What is the company's minimum rate of return, after taxes, desired for investments?

Obtaining this information may require making some assumptions, and the conclusion is only as good as the assumptions. That means it's critical that the affected department managers be consulted regarding the impact on their area of responsibility. If making the investment will increase production, what is the increase and can that increased production be sold and at what price? Will the investment reduce per unit production costs? Assumptions regarding these production and sales factors must be made, and the respective managers must make them. In other words, they must "take ownership" of, or be accountable for, assumptions in their area of responsibility if your analysis is going to be the basis of a decision made by upper management.

Once you have the assumed sales and production cost numbers, and the respective managers are in agreement with the numbers, you are ready to analyze the financial consequences of making the investment. Statistical tables, relative tax rates, and company policy help you in "determining a good investment". You will likely have a book of tables for various types of equipment listing the expected economic life for each type. These tables likely have already been approved by your company's upper management and/or the federal government.

The federal government may determine the economic life of equipment, and its rate of depreciation, based on studies it has done, because depreciation is a legitimate, but non-cash, expense the "shields" income from being taxed. The equipment may be depreciated in equal annual "installments" over its economic life, or some form of accelerated depreciation may be allowed. Accelerated depreciation is preferred because it allows you to get your investment back sooner through tax savings as a result of the tax "shield".

Once your increased revenues (sales) net of your increased costs, or simply the reduction in your cost of goods sold, and your depreciation expense have been determined, you are ready to calculate the effect on your cash flow and its impact on your "bottom line".

The value of a dollar changes over time. For example, if you loaned someone $100 at 5% interest, but you want your interest up front, you would give him $95.24, keeping the difference as your interest ($100/1.05=$95.24, or $95.24x1.05=$100). If your investment has an economic life of 10 years, then the increased cash flows, when discounted for each of the10 years at the minimum rate of return, after taxes, desired by your company should equal or exceed the present value of the amount of investment, including taxes and any other associated costs, you will have to make to obtain the equipment installed and ready to put into production.

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