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Use the Capital you've invested in your business effectively: We'll tell you why

by , 07 March 2013
Without a sound capital investment appraisal method, you could make the wrong investment decisions. And your business cash flows could suffer - severely.

Not only does the wrong investment decision cost you money directly, because of the money you have to spend, but it will also cost you in the long run if the asset you invested in doesn't perform the way you need it to. 

The wrong decision may cause big ripples in your company, making all your hard work setting up your business for nothing.
 
The experts at the Practical Accountancy Loose Leaf, have put their heads together about this problem.

They've targeted one capital investment appraisal method which will give you an accurate idea of how much your assets are worth.

There are three other capital investment appraisal methods you can use but this is the one that will normally give you a reliable enough picture of your options.

Let's have a look at this method – the net present value capital investment method.

Analyse your assets correctly with the net present value capital investment method

The net present value (NPV) capital investment method compares how much you invested in an asset a number of years ago versus the price you would pay to replace that asset now.

Let's take a look at an example.

Example

John's owned a debt collection firm, DebtsRUs, for several years.  He wants to retire and sell his company. He has a yearly cash flow of R12 000 000 and his cost of capital, in other words how much the funds that he uses in his business are costing him, is 10%.

A friend advised him the best way to find a buyer for his business is to find out the net present value of his company's cash flows. This friend told John that the price for his business should be set so that a potential buyer will earn at least the same from his investment in the company as he would have if he left his money in the bank.

John worked out the NPV of DebtsRUs' cash flows at R109 090 90.90 (R12 000 000 (John's company's yearly cash flow) /(1 + 10% (the company's cost of capital)).

This means that an investment of R10 909 091 today would return R12 000 000 per year, so John should be able to sell his company as long as the price isn't higher than that!


In chapter C02: Capital Investment Appraisal, in the Practical Accountancy Loose Leaf  we show  you how you can use the other three methods to appraise your capital investment:
  • Payback period;
  • Average accounting rate of return; and
  • Internal rate of return (IRR).

If you don't subscribe to the Practical Accountancy Loose Leaf, follow this link and discover the ins and outs of capital investment appraisal.

Until next week,


Philip Rosenberg


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