Return on Investment (ROI) analysis takes the expected cash flows generated by a capital project and compares it to the cost of the initial investment. Companies should calculate return on investment whenever they make a capital expenditure (a sizable investment for an asset that is expected to generate revenue and profit in the future).
Return on investment, capital expenditures, Cap-ex, capital investments, and capital budgeting are used interchangeably by many companies but they’re usually referring to the same thing, the process of deciding what capital investments to make to improve the value of the company.
When you perform an ROI analysis—and sooner or later you will probably be asked to do so—you add up all the estimated costs associated with bringing the project online, estimate the likely returns over the investment’s life, and calculate the return on investment. That gives you the information you need to make the decision.
But be careful! ROI analysis isn’t as simple as it sounds. You have to account for the time value of money. You have to estimate returns based on cash flow rather than on profit. You must know your company’s hurdle rates, and you must determine which method of calculating ROI is the best one for your project.
(Excerpts from Financial Intelligence, Chapter 27 – Figuring ROI)
The key to useful ROI analysis – and the most difficult part of any method – is to make good estimates of the future benefits of an investment. It is where the real challenge lies and where the most common mistakes are made. Even big companies find this hard. Just look at the number of acquisitions or other major investments that don’t pay off. These bad investments almost always reflect unrealistic projections of the project’s future economic benefits.