Making investments in fixed assets like property, plant and equipment is a crucial decision for companies. It requires careful financial analysis to determine the feasibility and potential return on such large capital outlays. When examining a potential fixed asset acquisition, there are some key formulas and examples to consider around factors like sunk costs, depreciation, tax impacts, salvage value and more. Properly incorporating these into an investment analysis can help ensure companies make sound decisions that maximize shareholder value. This article will explore some of the key formulas and metrics to factor in when evaluating fixed capital investments.
Incorporate sunk costs correctly in fixed capital investment formulas
Sunk costs refer to any funds already spent in the past that cannot be recovered. These should not be included when calculating cash flows for a new investment decision. For example, if $50,000 was already spent on planning and permits for a new factory site, that cost is sunk and irrelevant to determining the feasibility of actually constructing the factory.
Account for depreciation impacts in fixed capital investment analysis
Since fixed assets like machinery lose value over time, the depreciation schedule is a key input into investment formulas. Tax laws often allow accelerated depreciation early on, enhancing returns. For example, a $1 million piece of equipment may depreciate by $350k in the first 3 years under tax codes. This generates a useful tax shield and cash flow.
Consider after-tax salvage value in fixed capital formulas
The projected future resale value of fixed assets also factors into investment math. This is particularly true if the salvage value differs substantially from the depreciated book value at that future point. Calculating the after-tax proceeds if sold, and factoring this into capital budgeting formulas, provides a more accurate analysis.
Account for working capital needs in fixed investment formulas
In addition to the direct cash outlay on fixed asset purchases, increasing output often requires higher investment in working capital like inventories and receivables. Formulas should factor in these incremental working capital needs over the life of the project to arrive at true relevant cash flows.
Evaluating investments in fixed capital like property and equipment requires careful analysis across factors like depreciation schedules, tax impacts, working capital needs, and salvage potential. Correctly incorporating these into capital budgeting formulas like NPV can help ensure companies make sound financial decisions.