Initial investment is the amount required to start a business or a project. It is also called initial investment outlay or simply initial outlay.
Capital budgeting decisions involve careful estimation of the initial investment outlay and future cash flows of a project. Correct estimation of these inputs helps in taking decisions that increase shareholders wealth.
Initial investment equals the amount needed for capital expenditures, such as machinery, tools, shipment and installation, etc.; plus any increase in working capital, minus any after tax cash flows from disposal of any old assets. Sunk costs are ignored because they are irrelevant.
Initial Investment = Capital Expenditures + Increase in Working Capital − Disposal Inflows
Saindak Copper Company Ltd (SCCL) started a copper and gold exploration and extraction project in Baluchistan in 20X5. In 20X6-20X7, it incurred expenditure of $200 million on seismic studies of the area and $500 million on equipment, etc. In 20X8, the company abandoned the project due to disagreement with the government. Recently, a new business friendly government is sworn in. SCCL managing director believes the project needs reconsideration. The company's financial analyst and chief engineer estimate that $1,500 million worth of new equipment is needed to restart the project. Shipment and installation expenditures would amount to $200 million. Current assets must increase by $200 million and current liabilities by $90 million. The equipment purchased in 20X6-20X7 is no longer useful and is to be disposed of for after tax proceeds of $120 million. Find the initial investment outlay.
= equipment purchase price + shipment and installation + increase in working capital − disposal inflows
= $1,500 million + $200 million + ($200 million − $90 million) - $120 million = $1,690 million.
SCCL needs $1,690 million to restart the project. It needs to estimate future cash flows from the project, and calculate net present value and/or internal rate of return in order to decide whether to go ahead with the restart or not.
$200 million expenditure on the seismic studies is not part of the initial investment because it is a sunk cost.
Written by Obaidullah Jan