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Strategic investments \u2014 such as expanding a plant, purchasing a major piece of equipment or introducing a new product line \u2014 can add long-term value. But management shouldn\u2019t base these decisions on gut instinct. A comprehensive, formal analysis can help minimize the guesswork and maximize your return on investment.<\/p>\n
Forecasting cash flows <\/strong><\/p>\n Financial forecasts typically start with the most recent income statement. Then assumptions are made about 1)\u00a0how much revenue (or cost savings) will the project generate, and 2)\u00a0what incremental expenses will the project incur. In some cases, a project may create special tax savings (for example, first-year bonus depreciation or Section\u00a0179 deductions) that may need to be factored into the decision.<\/p>\n Strategic investments will also affect your company\u2019s balance sheet and statements of cash flows. For example, they may require additional working capital and fixed assets. Preparing comprehensive financial forecasts helps management evaluate how much cash the project will need each period and whether internal resources will be sufficient to finance it. Some projects will require the company to tap into the company\u2019s line of credit \u2014 or require additional loans or capital contributions.<\/p>\n Comparing investment alternatives<\/strong><\/p>\n Company resources are limited. So, once cash flows have been forecasted, it\u2019s time to analyze the results and prioritize competing investment alternatives. For example, you might have $50,000 to invest in either a new machine or IT upgrades. Which alternative is better from a financial perspective?<\/p>\n Three financial tools that are used to evaluate such decisions include:<\/p>\n 1. Accounting payback period.<\/strong> This tells you how long it will take for a project to recoup its initial investment and start generating positive net cash flow \u2014 without considering the time value of money. For example, suppose a new machine that costs $48,000 is expected to generate $12,000 of incremental cash flow annually. Its accounting payback period would be four years ($48,000 divided by $12,000).<\/p>\n 2. Net present value (NPV).<\/strong> This is a tool that discounts each period\u2019s forecasted cash flow into its present value. The sum of the present values for all the periods equals the project\u2019s NPV. If NPV is greater than zero, the project will generate positive cash flow and it\u2019s worth considering. If not, the project may not be worthwhile. Typically, management uses the company\u2019s cost of capital \u2014 or possibly a rate based on the risk of the investment \u2014 to discount forecasted cash flow.<\/p>\n 3. Internal rate of return (IRR).<\/strong> This tool estimates a project\u2019s expected return on investment. This is the point at which a project\u2019s NPV equals zero. Management typically has a preset hurdle rate that a project must exceed to be considered. For example, if management sets its hurdle rate at 13%, any project with an IRR below 13% will be on the chopping block.<\/p>\n These financial tools may sometimes conflict with one another. So, it\u2019s important to consider qualitative factors, too. For example, IT upgrades might also protect against cyberattacks and reputational harm, which may be difficult to quantify in financial forecasts.<\/p>\n Need help?<\/strong><\/p>\n Contact us to evaluate the quantitative and qualitative effects of strategic investment alternatives. We can help determine what\u2019s right for your situation.<\/p>\n \u00a9 2021<\/em><\/p>\n <\/body> Strategic investments \u2014 such as expanding a plant, purchasing a major piece of equipment or introducing a new product line \u2014 can add long-term value. But management shouldn\u2019t base these decisions on gut instinct. A comprehensive, formal analysis can help minimize the guesswork and maximize your return on investment. Forecasting cash flows Financial forecasts typically […]<\/p>\n","protected":false},"author":3,"featured_media":0,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[13,7,10],"tags":[8,11,12],"class_list":["post-15454","post","type-post","status-publish","format-standard","hentry","category-aa","category-articles","category-news","tag-articles","tag-news","tag-updates"],"_links":{"self":[{"href":"https:\/\/www.sfw.cpa\/news-and-guides\/wp-json\/wp\/v2\/posts\/15454","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/www.sfw.cpa\/news-and-guides\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/www.sfw.cpa\/news-and-guides\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/www.sfw.cpa\/news-and-guides\/wp-json\/wp\/v2\/users\/3"}],"replies":[{"embeddable":true,"href":"https:\/\/www.sfw.cpa\/news-and-guides\/wp-json\/wp\/v2\/comments?post=15454"}],"version-history":[{"count":0,"href":"https:\/\/www.sfw.cpa\/news-and-guides\/wp-json\/wp\/v2\/posts\/15454\/revisions"}],"wp:attachment":[{"href":"https:\/\/www.sfw.cpa\/news-and-guides\/wp-json\/wp\/v2\/media?parent=15454"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/www.sfw.cpa\/news-and-guides\/wp-json\/wp\/v2\/categories?post=15454"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/www.sfw.cpa\/news-and-guides\/wp-json\/wp\/v2\/tags?post=15454"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}
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