Capital investments are big, expensive projects that provide benefits over many years, and often generate income to help pay for themselves. They typically require financing (borrowing), and a convincing argument for why they’re worth it.
Story: Solar Panels for Your Birthday
Say you’re you’re a kid who’s worried about climate change. You ask your parents to install solar panels as a birthday present. You’ve just proposed a capital investment.
Most birthday presents wouldn’t be considered capital investments, because you’ll just use them for a couple of years at most… and they won’t generate any revenue.
But solar panels are expensive, will last decades, and could (depending where you live) save you lots of money on your family electricity bill.
So you sit down with your mom (the family finance whiz) to work out the details. Here’s what you two discover:
- The panels will cost $14,000 for a six-kilowatt system, installed.
- They’ll save your family $2,000 a year in electricity costs.
- There’s an option to buy a 14 KwH storage battery for $10,000, which can store the energy, saving an additional $1,000 per year.
- This battery would also provide backup power in case of power outages.
Based on this information, your mom asks the following questions:
- What is the payback period on the solar panels? (how long will it take for them to pay for themselves) Answer = $14,000/$2,000 = seven years.
- What is the payback period on the storage battery? Answer = $10,000/$1,000 = ten years.
- If we borrow the money to buy the panels (and the optional storage), what interest rate can we get, and how much longer does it then take the system to pay for itself (because of the added interest costs)?
- Should we place a monetary value on having backup power in case of an outage, and what is that value (it could shorten the ‘payback period’)?
- Do we place any value on doing the right thing by the environment with this investment? (a non-financial consideration)?
These same questions get asked about most capital investments, like bridges, roads, machinery… almost any infrastructure you can imagine. Someone must put all the numbers down to prove that it makes sense.
And then the decision makers decide whether to do the project, based on these numbers (plus other non-financial factors).
So should you get solar panels for your birthday?
See what your mom says.