What metrics should you use to measure the profitability of a capital investment?

Capital investments are long-term projects that require a significant amount of money, such as buying new equipment, expanding facilities, or acquiring another business. These decisions can have a major impact on the future performance and value of your company, so you need to evaluate them carefully and choose the ones that offer the best return. But how do you measure the profitability of a capital investment? What metrics should you use to compare different options and assess their feasibility and attractiveness? In this article, we will discuss four common metrics that can help you answer these questions: payback period, net present value, internal rate of return, and profitability index.

1 Payback period

The payback period is the simplest metric to calculate and understand. It measures how long it takes for a capital investment to recover its initial cost from the cash flows it generates. For example, if you invest $100,000 in a project that produces $20,000 of cash flow per year, the payback period is five years. The shorter the payback period, the faster you can recoup your investment and the lower the risk of losing money. However, the payback period has some limitations. It does not consider the time value of money, which means that it ignores the fact that a dollar today is worth more than a dollar in the future. It also does not account for the cash flows that occur after the payback period, which may differ significantly among different projects.

Add your perspective

Asha Kanta Sharma

Manager - Finance & Accounts @ Opendoors Fintech | Financial Accounting
Report contribution
Capital investment profitability is determined by assessing its financial performance and return on investment (ROI). Key metrics to consider include Return on Investment (ROI), Net Present Value (NPV), Internal Rate of Return (IRR), Payback Period, Profitability Index (PI), Accounting Rate of Return (ARR), Return on Capital Employed (ROCE), Economic Value Added (EVA), Cash-on-Cash Return, Return on Equity (ROE), Gross Profit Margin, Operating Profit Margin, Net Profit Margin, Break-Even Point, Operating Cash Flow Ratio, Debt Service Coverage Ratio (DSCR), Sensitivity Analysis, Scenario Analysis, Risk-Adjusted Return (RAR), and Market Share and Positioning.

Like

2 Net present value

The net present value (NPV) is a more sophisticated metric that addresses the shortcomings of the payback period. It calculates the difference between the present value of the cash inflows and the present value of the cash outflows of a capital investment, using a discount rate that reflects the cost of capital and the risk of the project. The present value is the amount that a future cash flow is worth today, based on the principle that money can earn interest over time. For example, if you invest $100,000 in a project that produces $20,000 of cash flow per year for 10 years, and the discount rate is 10%, the NPV is $21,948. The higher the NPV, the more profitable the project is. A positive NPV means that the project exceeds the required rate of return, while a negative NPV means that the project fails to meet it.

Add your perspective

3 Internal rate of return

The internal rate of return (IRR) is another metric that evaluates the profitability of a capital investment. It is the discount rate that makes the NPV of a project equal to zero. In other words, it is the rate of return that the project earns over its lifetime. For example, if you invest $100,000 in a project that produces $20,000 of cash flow per year for 10 years, the IRR is 11.8%. The higher the IRR, the more profitable the project is. A project is acceptable if its IRR is greater than or equal to the cost of capital, and rejected if its IRR is less than the cost of capital. However, the IRR may not be reliable if the project has multiple or unconventional cash flows, or if there are more than one project to choose from.

Add your perspective

4 Profitability index

The profitability index (PI) is a ratio that compares the present value of the cash inflows and the present value of the cash outflows of a capital investment. It is calculated by dividing the present value of the cash inflows by the present value of the cash outflows. For example, if you invest $100,000 in a project that produces $20,000 of cash flow per year for 10 years, and the discount rate is 10%, the PI is 1.22. The higher the PI, the more profitable the project is. A PI greater than one means that the project creates value, while a PI less than one means that the project destroys value. The PI can be used to rank projects according to their profitability and efficiency.

Add your perspective

5 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?

Add your perspective

What metrics should you use to measure the profitability of a capital investment?

1

2

3

4

5

1 Payback period

2 Net present value

3 Internal rate of return

4 Profitability index

5 Here’s what else to consider

Accounting

Rate this article

Thanks for your feedback

More articles on Accounting

More relevant reading