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