If you plan to invest capital in premises, land or equipment you need to be able to work out the pros and cons of each investment opportunity. You can use capital investment techniques which estimate the income returns against all the outlays for the proposed investment over a period of time. This article summaries two types of capital investment techniques, the first type based on simple income estimates, and the second type based on discounted income estimates.

Investment techniques based on simple income estimates

The first kind based on simple income estimates compares the forecast income over the life of the project to the original capital outlay. We'll look at two investment techniques to do this. These are the Payback method and the average rate of return (ARR) method. Both are straightforward to use and hence very popular.

Payback Method

This technique calculates how long a project will take to pay for itself. To do this you estimate how much income will be generated per period over the life of the project and work out how long it takes for all the incoming income to total all the capital outlay. If you are choosing between more than one project you might choose the project with the shortest payback time. Sometimes you can also allow for depreciation amounts taken from the income stream. So in this situation you would deduct from the income a depreciation amount per time period, so you are in effect reducing the capital value you need to recover over time.

Average Rate of Return (ARR) method

This technique calculates the percentage of total income generated over the total cost of the project. So the average rate of return (ARR) uses the same data as the Payback method but calculates the total income as a percentage of total capital costs. The number of time periods has no significance to the calculation, and again if you are choosing between more than one project you might choose the one with the highest ARR.

Investment techniques based on discounted income estimates

The second type of capital investment technique recognizes that the value of money reduces over time. For example if you spend £10 on a particular kind of apple today you get 30 apples. If you wait a year and then buy the same 30 apples you find you have to pay £10.50. So £10.50 in one year's time is worth £10 today, which is a reduction of 4.8%. So we can say the £10.50 is discounted by 4.8% to convert to today's value. We'll look at two investment techniques which use discounting to convert future income amounts to today's values. These are Net Present Value (NPV) and Internal Rate of Return (IRR).

Net Present Value (NPV) method

This technique totals discounted future income generated by a project over its estimated life at fixed or different interest rates per period and deducts the total original capital investment to give a value of the worth of the project, the Net Present Value. The technique is very similar to the Payback method but uses discounted future incomes. A positive NPV indicates project is worth going ahead with and a negative NPV would suggest the reverse. Although more complex than Payback, the NPV method more accurately reflects the time value of money. NPV can also allow for different discount rates for different periods and can be particularly relevant for times of high inflation rates. If you're comparing more than one investment opportunity then you would tend to choose the one with the highest NPV.

Internal Rate of Return, IRR

This technique calculates the rate at which future income must be discounted back to the present day to equal the total original investment, so that the NPV is zero. In other words IRR is the discount rate which achieves a zero NPV for the project. The IRR rate can then be compared, for example, with the rate to borrow the original capital. If the IRR is higher than the borrowing rate the project would be worth going ahead.

So in this brief article we've described two different kinds of Capital Investment techniques. The first kind compare total income streams to the original capital outlay, and the methods described were Payback and Average Rate of Return (ARR). Both are straightforward to use but do not take into account how money values changes over time. The second kind compares discounted income streams to the original capital outlay, and the methods described were Net Present Value (NPV) and Internal Rate of Return (IRR), both of which discount future money to today's values.

Interested in learning more about Capital Investment techniques? A really good way is to attend an instructor lead training course. The best ones can really widen your horizons.