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25.1 Describe Capital Investment Decisions and How They Are Applied

What Are Capital Investment Decisions?​

Capital investments are expenditures for assets expected to provide benefits over multiple years. Examples include:

  • Opening new locations
  • Purchasing machinery or equipment
  • Developing new products or services
  • Expanding into new markets
  • Implementing new IT systems
  • Acquiring another company

Capital budgeting decisions involve:

  • Estimating project cash flows
  • Assessing risk and cost of capital
  • Evaluating using financial metrics
  • Comparing alternatives
  • Making go/no-go decisions

Capital Budgeting Process​

  1. Identify Opportunities: Strategic initiatives, regulatory requirements, maintenance needs
  2. Gather Data: Estimate costs, cash inflows, useful life, salvage value
  3. Estimate Cash Flows: Incremental cash inflows and outflows
  4. Assess Risk: Market risk, technology risk, execution risk
  5. Determine Cost of Capital: Weighted average cost of capital (WACC) or hurdle rate
  6. Apply Evaluation Techniques: Payback, ARR, NPV, IRR, PI
  7. Select Projects: Based on criteria and strategic fit
  8. Implement and Monitor: Track actual performance vs. projections

Types of Capital Projects​

  • Growth Projects: Expand capacity, enter new markets
  • Replacement Projects: Replace outdated equipment
  • Compliance Projects: Meet regulatory or safety requirements
  • Strategic Projects: Align with long-term strategy (innovation, digital transformation)
  • Sustainability Projects: Reduce environmental impact, meet ESG goals

Relevant Costs and Benefits​

Only incremental cash flows matter:

  • Include: Additional revenues, cost savings, working capital changes, tax effects, salvage value
  • Exclude: Sunk costs (past expenditures), allocated costs unrelated to project

Common Cash Flow Components​

  • Initial investment (capital expenditure, installation)
  • Additional working capital (inventory, receivables)
  • Operating cash flows (revenue, cost savings, operating expenses)
  • Tax effects (depreciation shield, tax on profit)
  • Terminal cash flows (salvage value, working capital recovery)

Qualitative Factors​

Not all decisions can be based solely on numbers. Consider:

  • Strategic importance
  • Competitive position
  • Customer impact
  • Regulatory requirements
  • Environmental and social impact

Luxembourg Compliance Note​

In Luxembourg, capital investments may qualify for government grants (e.g., digitalization, energy efficiency) through institutions like Luxinnovation. Capital budgeting should evaluate grant eligibility, VAT treatment, and tax implications (accelerated depreciation, investment tax credits).

Think It Through​

Why is it important to consider both quantitative and qualitative factors in capital budgeting? Can you think of an investment where the numbers looked good but strategic factors said otherwise?