Evaluating Revenue-Producing Projects

The approach for evaluating capital expenditures depends on if the project is revenue or non-revenue producing

There are three methods to evaluate revenue-producing projects

How does an asset manager decide which capital expenditures should be approved? The answer differs depending on whether the proposed project is a revenue-producing project, such as a new spa, or a non-revenue-producing project, such as a new dishwasher or heating system. We will consider both, beginning with revenue-producing projects. Asset managers can utilize a number of tools to evaluate such projects, all meant to help calibrate the return on the project and compare it to other proposed projects. Consider the three main methods:

Net Present Value (NPV)
This is the preferred tool. It clearly shows the change in wealth produced by an investment. It does, however, have shortcomings.
- Comparison of alternative projects with different scales can be difficult.
- NPV requires good knowledge of the cost of capital or the required rate of return.
- NPV requires that all relevant cash flows be considered.
Internal Rate of Return (IRR)
This is a widely used tool. It allows the analyst to compare the IRR to some required rate of return or cost of capital. It also has shortcomings, however.
- It can produce results at odds with the NPV criterion.
- With sign changes in the cash flows, an alternative can give multiple IRRs.
- Which to use, the IRR or the marginal IRR?
Profitability Index (PI)
This is defined as the sum of the present values of the benefits, divided by the initial investment. The PI of the investment below is 1.17.

Year 0 $ − 100

Year 1 $ 20 (PV of benefits @ 10% is $117.36)

Year 2 $ 120

The strengths of the PI include:
- PI is a direct measure of the value increase per dollar invested.
- PI is an indicator of risk; for example, a PI of 1.3 implies that benefits are 30% greater than those needed to break even.
The shortcomings of PI include:
- Is the denominator just the initial investment or the PV of all negative outflows? The modified PI takes the latter approach.
- The PI is virtually useless for ranking investments of different scale. A PI of 2.0 on an investment of $100 is very different from a PI of 1.4 on an investment of $1,000,000.
- There is little relationship between PI and wealth creation.

In brief, each of the major tools has weaknesses. An effective asset manager must be able to use all three. The best decisions utilize all three tools, interpreting the results according to the strengths and weaknesses of each method.