# Initial Investment

Initial investment is the amount required to start a business or a project. It is also called initial investment outlay or simply initial outlay. It equals capital expenditures plus working capital requirement plus after-tax proceeds from assets disposed off or available for use elsewhere.

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.

## Formula

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 = CapEx + ΔWC + D

Where,
CapEx is capital expenditure,
∆WC is the change in working capital and
D is the net cash flow from disposed asset.

## Example

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.

### Solution

Initial investment
= 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.

by Obaidullah Jan, ACA, CFA and last modified on

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