How can you identify the most promising capital equipment investments for your portfolio?

1 Net present value

Net present value (NPV) is a method that calculates the present value of the future cash flows of a project, minus the initial investment. It represents the net gain or loss from investing in a project, and it can help you compare different projects based on their profitability. A positive NPV means that the project is profitable and adds value to your portfolio, while a negative NPV means that the project is unprofitable and reduces value. To calculate NPV, you need to estimate the future cash flows of the project, and discount them using an appropriate discount rate, which reflects the opportunity cost and risk of the project.

2 Internal rate of return

Internal rate of return (IRR) is a method that calculates the discount rate that makes the NPV of a project equal to zero. It represents the annualized rate of return that the project generates, and it can help you compare different projects based on their efficiency. A higher IRR means that the project is more efficient and has a higher return potential, while a lower IRR means that the project is less efficient and has a lower return potential. To calculate IRR, you need to find the discount rate that makes the present value of the future cash flows of the project equal to the initial investment.

3 Payback period

Payback period is a method that calculates the time it takes for a project to recover its initial investment. It represents the liquidity and risk of the project, and it can help you compare different projects based on their cash flow recovery. A shorter payback period means that the project has a faster cash flow recovery and a lower risk, while a longer payback period means that the project has a slower cash flow recovery and a higher risk. To calculate payback period, you need to divide the initial investment by the annual cash flow of the project.

4 Profitability index

Profitability index (PI) is a method that calculates the ratio of the present value of the future cash flows of a project to the initial investment. It represents the benefit-cost ratio of the project, and it can help you compare different projects based on their relative profitability. A PI greater than one means that the project is profitable and has a positive NPV, while a PI less than one means that the project is unprofitable and has a negative NPV. To calculate PI, you need to divide the present value of the future cash flows of the project by the initial investment.

5 Capital asset pricing model

Capital asset pricing model (CAPM) is a method that calculates the expected return of a project, based on its systematic risk and market return. It represents the risk-adjusted return of the project, and it can help you compare different projects based on their risk-reward trade-off. A higher expected return means that the project has a higher risk-adjusted return and a higher reward potential, while a lower expected return means that the project has a lower risk-adjusted return and a lower reward potential. To calculate the expected return, you need to estimate the risk-free rate, the market return, and the beta of the project, which measures its sensitivity to market movements.

6 Sensitivity analysis

Sensitivity analysis is a method that evaluates how the NPV of a project changes when one or more of the input variables change. It represents the uncertainty and volatility of the project, and it can help you assess the impact of different scenarios and assumptions on the project's profitability. A higher sensitivity means that the project's NPV is more affected by changes in the input variables and has a higher volatility, while a lower sensitivity means that the project's NPV is less affected by changes in the input variables and has a lower volatility. To perform sensitivity analysis, you need to vary one or more of the input variables, such as cash flows, discount rate, or growth rate, and observe how the NPV of the project changes.

7 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?