Financial Terms capital investment analysis

# Definition of capital investment analysis

## capital investment analysis

Refers to various techniques and procedures
used to determine or to analyze future returns from an investment
of capital in order to evaluate the capital recovery pattern and the
periodic earnings from the investment. The two basic tools for capital
investment analysis are (1) spreadsheet models (which I strongly prefer)
and (2) mathematical equations for calculating the present value or
internal rate of return of an investment. Mathematical methods suffer
from a lack of information that the decision maker ought to consider. A
spreadsheet model supplies all the needed information and has other

# Related Terms:

## capital recovery

Refers to recouping, or regaining, invested capital over
the life of an investment. The pattern of period-by-period capital recovery
is very important. In brief, capital recovery is the return of capitalâ€”
not the return on capital, which refers to the rate of earnings on the
amount of capital invested during the period. The returns from an
investment have to be sufficient to provide for both recovery of capital
and an adequate rate of earnings on unrecovered capital period by
period. Sorting out how much capital is recovered each period is relatively
easy if you use a spreadsheet model for capital investment analysis.
In contrast, using a mathematical method of analysis does not
provide this period-by-period capital recovery information, which is a

## cost of capital

Refers to the interest cost of debt capital used by a business
plus the amount of profit that the business should earn for its equity
sources of capital to justify the use of the equity capital during the
period. Interest is a contractual and definite amount for a period,
whereas the profit that a business should earn on the equity capital
employed during the period is not. A business should set a definite goal
of earning at least a certain minimum return on equity (ROE) and compare
its actual performance for the period against this goal. The costs of
debt and equity capital are combined into either a before-tax rate or an
after-tax rate for capital investment analysis.

## discounted cash flow (DCF)

Refers to a capital investment analysis technique
that discounts, or scales down, the future cash returns from an
investment based on the cost-of-capital rate for the business. In essence,
each future return is downsized to take into account the cost of capital
from the start of the investment until the future point in time when the
return is received. Present value (PV) is the amount resulting from discounting
the future returns. Present value is subtracted from the entry
cost of the investment to determine net present value (NPV). The net
present value is positive if the present value is more than the entry cost,
which signals that the investment would earn more than the cost-ofcapital
rate. If the entry cost is more than the present value, the net
present value is negative, which means that the investment would earn
less than the businessâ€™s cost-of-capital rate.

## Average cost of capital

A firm's required payout to the bondholders and to the stockholders expressed as a
percentage of capital contributed to the firm. Average cost of capital is computed by dividing the total
required cost of capital by the total amount of contributed capital.

## BARRA's performance analysis (PERFAN)

A method developed by BARRA, a consulting firm in
Berkeley, Calif. It is commonly used by institutional investors applying performance attribution analysis to
evaluate their money managers' performances.

## Break-even analysis

An analysis of the level of sales at which a project would make zero profit.

## Capital

Money invested in a firm.

## Capital account

Net result of public and private international investment and lending activities.

## Capital allocation

decision Allocation of invested funds between risk-free assets versus the risky portfolio.

## Capital asset pricing model (CAPM)

An economic theory that describes the relationship between risk and
expected return, and serves as a model for the pricing of risky securities. The CAPM asserts that the only risk
that is priced by rational investors is systematic risk, because that risk cannot be eliminated by diversification.
The CAPM says that the expected return of a security or a portfolio is equal to the rate on a risk-free security

## Capital budget

A firm's set of planned capital expenditures.

## Capital budgeting

The process of choosing the firm's long-term capital assets.

## Capital expenditures

Amount used during a particular period to acquire or improve long-term assets such as
property, plant or equipment.

## Capital flight

The transfer of capital abroad in response to fears of political risk.

## Capital gain

When a stock is sold for a profit, it's the difference between the net sales price of securities and
their net cost, or original basis. If a stock is sold below cost, the difference is a capital loss.

## Capital gains yield

The price change portion of a stock's return.

## Capital lease

A lease obligation that has to be capitalized on the balance sheet.

## Capital loss

The difference between the net cost of a security and the net sale price, if that security is sold at a loss.

## Capital market

The market for trading long-term debt instruments (those that mature in more than one year).

## Capital market efficiency

Reflects the relative amount of wealth wasted in making transactions. An efficient
capital market allows the transfer of assets with little wealth loss. See: efficient market hypothesis.

## Capital market imperfections view

The view that issuing debt is generally valuable but that the firm's
optimal choice of capital structure is a dynamic process that involves the other views of capital structure (net
corporate/personal tax, agency cost, bankruptcy cost, and pecking order), which result from considerations of
asymmetric information, asymmetric taxes, and transaction costs.

## Capital market line (CML)

The line defined by every combination of the risk-free asset and the market portfolio.

## Capital rationing

Placing one or more limits on the amount of new investment undertaken by a firm, either
by using a higher cost of capital, or by setting a maximum on parts of, and/or the entirety of, the capital
budget.

## Capital structure

The makeup of the liabilities and stockholders' equity side of the balance sheet, especially
the ratio of debt to equity and the mixture of short and long maturities.

## Capital surplus

Amounts of directly contributed equity capital in excess of the par value.

## Capitalization

The debt and/or equity mix that fund a firm's assets.

## Capitalization method

A method of constructing a replicating portfolio in which the manager purchases a
number of the largest-capitalized names in the index stock in proportion to their capitalization.

## Capitalization ratios

Also called financial leverage ratios, these ratios compare debt to total capitalization
and thus reflect the extent to which a corporation is trading on its equity. capitalization ratios can be
interpreted only in the context of the stability of industry and company earnings and cash flow.

## Capitalization table

A table showing the capitalization of a firm, which typically includes the amount of
capital obtained from each source - long-term debt and common equity - and the respective capitalization
ratios.

## Capitalized

Recorded in asset accounts and then depreciated or amortized, as is appropriate for expenditures
for items with useful lives greater than one year.

## Capitalized interest

Interest that is not immediately expensed, but rather is considered as an asset and is then
amortized through the income statement over time.

## Cluster analysis

A statistical technique that identifies clusters of stocks whose returns are highly correlated
within each cluster and relatively uncorrelated between clusters. Cluster analysis has identified groupings
such as growth, cyclical, stable and energy stocks.

## Common-base-year analysis

The representing of accounting information over multiple years as percentages
of amounts in an initial year.
Common-size analysis The representing of balance sheet items as percentages of assets and of income
statement items as percentages of sales.

## Comparative credit analysis

A method of analysis in which a firm is compared to others that have a desired
target debt rating in order to infer an appropriate financial ratio target.

## Complete capital market

A market in which there is a distinct marketable security for each and every
possible outcome.

## Cost of capital

The required return for a capital budgeting project.

## Cost of limited partner capital

The discount rate that equates the after-tax inflows with outflows for capital
raised from limited partners.

## Credit analysis

The process of analyzing information on companies and bond issues in order to estimate the
ability of the issuer to live up to its future contractual obligations. Related: default risk

## Dedicated capital

Total par value (number of shares issued, multiplied by the par value of each share). Also
called dedicated value.

## Discriminant analysis

A statistical process that links the probability of default to a specified set of financial ratios.

## Dividend reinvestment plan (DRP)

Automatic reinvestment of shareholder dividends in more shares of a
company's stock, often without commissions. Some plans provide for the purchase of additional shares at a
discount to market price. Dividend reinvestment plans allow shareholders to accumulate stock over the Long
term using dollar cost averaging. The DRP is usually administered by the company without charges to the
holder.

## Efficient capital market

A market in which new information is very quickly reflected accurately in share
prices.

## Expected return on investment

The return one can expect to earn on an investment. See: capital asset
pricing model.

## Factor analysis

A statistical procedure that seeks to explain a certain phenomenon, such as the return on a
common stock, in terms of the behavior of a set of predictive factors.

## Foreign direct investment (FDI)

The acquisition abroad of physical assets such as plant and equipment, with
operating control residing in the parent corporation.

## Fundamental analysis

Security analysis that seeks to detect misvalued securities by an analysis of the firm's
business prospects. Research analysis often focuses on earnings, dividend prospects, expectations for future
interest rates, and risk evaluation of the firm.

## Future investment opportunities

The options to identify additional, more valuable investment opportunities
in the future that result from a current opportunity or operation.

## Guaranteed investment contract (GIC)

A pure investment product in which a life company agrees, for a
single premium, to pay the principal amount of a predetermined annual crediting (interest) rate over the life of
the investment, all of which is paid at the maturity date.

## Hard capital rationing

capital rationing that under no circumstances can be violated.

## Horizon analysis

An analysis of returns using total return to assess performance over some investment horizon.

## Horizontal analysis

The process of dividing each expense item of a given year by the same expense item in
the base year. This allows for the exploration of changes in the relative importance of expense items over time
and the behavior of expense items as sales change.

## Human capital

The unique capabilities and expertise of individuals.

## Investment analysts

Related: financial analysts

## Investment bank

Financial intermediaries who perform a variety of services, including aiding in the sale of
securities, facilitating mergers and other corporate reorganizations, acting as brokers to both individual and
institutional clients, and trading for their own accounts. Underwriters.

## Investment decisions

Decisions concerning the asset side of a firm's balance sheet, such as the decision to
offer a new product.

A bond that is assigned a rating in the top four categories by commercial credit
rating companies. For example, S&P classifies investment grade bonds as BBB or higher, and Moodys'
classifies investment grade bonds as Ba or higher. Related: High-yield bond.

## Investment income

The revenue from a portfolio of invested assets.
investment management Also called portfolio management and money management, the process of
managing money.

## Investment manager

Also called a portfolio manager and money manager, the individual who manages a
portfolio of investments.

## Investment product line (IPML)

The line of required returns for investment projects as a function of beta
(nondiversifiable risk).

## Investment tax credit

Proportion of new capital investment that can be used to reduce a company's tax bill
(abolished in 1986).

## Investment trust

A closed-end fund regulated by the investment Company Act of 1940. These funds have a
fixed number of shares which are traded on the secondary markets similarly to corporate stocks. The market
price may exceed the net asset value per share, in which case it is considered at a "premium." When the
market price falls below the NAV/share, it is at a "discount." Many closed-end funds are of a specialized
nature, with the portfolio representing a particular industry, country, etc. These funds are usually listed on US
and foreign exchanges.

## Investment value

Related:straight value.

## Investments

As a discipline, the study of financial securities, such as stocks and bonds, from the investor's
viewpoint. This area deals with the firm's financing decision, but from the other side of the transaction.

## Issued share capital

Total amount of shares that are in issue. Related: outstanding shares.

## Legal capital

Value at which a company's shares are recorded in its books.

## Legal investments

investments that a regulated entity is permitted to make under the rules and regulations
that govern its investing.

## Long-term debt/capitalization

Indicator of financial leverage. Shows long-term debt as a proportion of the
capital available. Determined by dividing long-term debt by the sum of long-term debt, preferred stock and
common stockholder equity.

## Market capitalization

The total dollar value of all outstanding shares. Computed as shares times current
market price. It is a measure of corporate size.

## Market capitalization rate

Expected return on a security. The market-consensus estimate of the appropriate
discount rate for a firm's cash flows.

## Mean-variance analysis

Evaluation of risky prospects based on the expected value and variance of possible outcomes.

## Multiple-discriminant analysis (MDA)

Statistical technique for distinguishing between two groups on the
basis of their observed characteristics.

## Mutually exclusive investment decisions

investment decisions in which the acceptance of a project
precludes the acceptance of one or more alternative projects.

## Net investment

Gross, or total, investment minus depreciation.

## Net present value of future investments

The present value of the total sum of NPVs expected to result from
all of the firm's future investments.

## Net working capital

Current assets minus current liabilities. Often simply referred to as working capital.

## Nondiversifiability of human capital

The difficulty of diversifying one's human capital (the unique
capabilities and expertise of individuals) and employment effort.

## Opportunity cost of capital

Expected return that is foregone by investing in a project rather than in
comparable financial securities.

## Other capital

In the balance of payments, other capital is a residual category that groups all the capital
transactions that have not been included in direct investment, portfolio investment, and reserves categories. It
is divided into long-term capital and short-term capital and, because of its residual status, can differ from
country to country. Generally speaking, other long-term capital includes most non-negotiable instruments of a
year or more like bank loans and mortgages. Other short-term capital includes financial assets of less than a
year such as currency, deposits, and bills.

## Outstanding share capital

Issued share capital less the par value of shares that are held in the company's treasury.

## Passive investment strategy

See: passive management.

## Passive investment management

index without attempting to search out mispriced securities.

## Pecking-order view (of capital structure)

The argument that external financing transaction costs, especially
those associated with the problem of adverse selection, create a dynamic environment in which firms have a
preference, or pecking-order of preferred sources of financing, when all else is equal. Internally generated
funds are the most preferred, new debt is next, debt-equity hybrids are next, and new equity is the least
preferred source.

## Perfect capital market

A market in which there are never any arbitrage opportunities.

## Perfect market view (of capital structure)

analysis of a firm's capital structure decision, which shows the
irrelevance of capital structure in a perfect capital market.

The decomposition of a money manager's performance results to explain
the reasons why those results were achieved. This analysis seeks to answer the following questions: (1) What
were the major sources of added value? (2) Was short-term factor timing statistically significant? (3) Was
market timing statistically significant? And (4), Was security selection statistically significant?

## Personal tax view (of capital structure)

The argument that the difference in personal tax rates between
income from debt and income from equity eliminates the disadvantage from the double taxation (corporate
and personal) of income from equity.

## Pie model of capital structure

A model of the debt/equity ratio of the firms, graphically depicted in slices of
a pie that represent the value of the firm in the capital markets.

## Planned capital expenditure program

capital expenditure program as outlined in the corporate financial plan.

## Pro forma capital structure analysis

A method of analyzing the impact of alternative capital structure
choices on a firm's credit statistics and reported financial results, especially to determine whether the firm will
be able to use projected tax shield benefits fully.

## Real capital

Wealth that can be represented in financial terms, such as savings account balances, financial
securities, and real estate.

## Regression analysis

A statistical technique that can be used to estimate relationships between variables.

## Reinvestment rate

The rate at which an investor assumes interest payments made on a debt security can be
reinvested over the life of that security.

## Reinvestment risk

The risk that proceeds received in the future will have to be reinvested at a lower potential
interest rate.

## REIT (real estate investment trust)

Real estate investment trust, which is similar to a closed-end mutual
fund. REITs invest in real estate or loans secured by real estate and issue shares in such investments.

## REMIC (real estate mortgage investment conduit)

A pass-through tax entity that can hold mortgages
secured by any type of real property and issue multiple classes of ownership interests to investors in the form
of pass-through certificates, bonds, or other legal forms. A financing vehicle created under the Tax Reform
Act of 1986.

## Return on investment (ROI)

Generally, book income as a proportion of net book value.

## Scenario analysis

The use of horizon analysis to project bond total returns under different reinvestment rates
and future market yields.

## Sensitivity analysis

analysis of the effect on a project's profitability due to changes in sales, cost, and so on.

## Short-term investment services

Services that assist firms in making short-term investments.