24 Figuring ROI

The Nitty-Gritty

Capital expenditures. Cap-ex. Capital investments. Capital budgeting. And of course, return on investment, or ROI. Many companies use these terms loosely or even interchangeably, but they’re usually referring to the same thing, namely the process of deciding what capital investments to make to improve the value of the company.

In most entrepreneurial companies, resources for capital expenditures are limited, and there’s a lot of competition for what little is available. “This manager wants a new software application,” says Paul Saginaw of Zingerman’s, a specialty food company. “This manager wants a new mixer, this manager wants a new oven, and this manager wants a new POS [point-of-sale] system. In order to make good decisions among those choices, you have to learn how to evaluate the capital purchases you’re going to make and what the returns on those investments are going to be, so that you are being a really good steward of the limited resources you have.” That is precisely what this chapter is about.

ANALYZING CAPITAL EXPENDITURES

Capital expenditures are large projects that require a significant investment of cash. Every organization defines significant differently; some draw the line at $1,000, others at $5,000 or more. Capital projects are typically expected to help generate revenue or reduce costs for more than a year. The category is broad. It includes equipment purchases, business expansions, acquisitions, and the development of new products. A new marketing campaign can be considered a capital expenditure. So can the renovation of a building, the upgrade of a computer system, and the purchase of a new company car.

Expenditures like these are treated differently than ordinary purchases of inventory, supplies, utilities, and so on, for at least three reasons. One is simply that they require your company to commit large (and sometimes indeterminate) amounts of cash. A second is that they are typically expected to provide returns for several years, so the time value of money comes into play. A third is that they always entail some degree of risk. You may not know whether the expenditure will work—that is, whether it will deliver the expected results. Even if it does work as planned, you can’t know exactly how much cash the investment will help generate. We will outline the basic steps of analyzing capital expenditures and then teach you the three methods finance people generally use for calculating whether a given expenditure is worth making.

But please, remember that this, too, is an exercise in the art of finance. It’s actually kind of amazing: in larger companies, financial professionals can and do analyze proposed projects and make recommendations using a host of assumptions and estimates, and the results generally turn out well. They even enjoy the challenge of taking these unknowns and quantifying them in a way that makes their company more successful. With a little financial intelligence, you can do what they do. You may even want to involve some of the managers and employees who work for you. We know of an entrepreneurial company where the owners make a point of involving engineers and technicians in the capital budgeting process, precisely because they are likely to know more about what an investment in a steelfabricating plant, say, will actually produce. The CFO of this company likes to say that he’d rather teach those people a little finance than learn metallurgy himself.

So here’s how to go about it:

Step 1 in analyzing a capital expenditure is to determine the initial cash outlay. Even this step involves estimates and assumptions: you must make judgments about what a machine or project is likely to cost before it begins to generate revenue. If Zingerman’s is installing a new POS system, for instance, managers must consider not only the purchase price but also the costs of installation, of initial and ongoing training, of documenting the process, and of the turmoil in the business the new system will inevitably create. Typically, most of the costs are incurred during the first year, but some may spill over into year two or even year three. All these calculations should be done in terms of cash out the door, not in terms of decreased profits.
- Step 2 is to project future cash flows from the investment. (Again, you want to know cash inflows, not profit.) This is a tricky step—definitely an example of the art of finance—both because it is so difficult to predict the future and because there are many factors that need to be taken into account. (See the toolbox at the end of this part.) Business owners need to be conservative, even cautious, in projecting future cash flows from an investment. If the investment returns more than projected, everybody will be happy. If it returns significantly less, no one will be happy, and you may well have wasted your company’s money.
- Step 3, finally, is to evaluate the future cash flows—to figure the return on investment. Are they substantial enough so that the investment is worth making? On what basis can we make that determination? Finance professionals typically use three different methods—alone or in combination—for deciding whether a given expenditure is worth it: the payback method, the net present value (NPV) method, and the internal rate of return (IRR) method. Each provides different information, and each has its characteristic strengths and weaknesses.

You can see right away that most of the work and intelligence in good capital budgeting involves the estimates of costs and returns. A lot of data must be collected and analyzed—a tough job in and of itself. Then the data has to be translated into projections about the future. Financially savvy entrepreneurs will understand that both of these are difficult processes and will examine their assumptions closely.

LEARNING THE THREE METHODS

To help you see these steps in action and understand how they work, we’ll take a simple example. You’re considering buying a $3,000 piece of equipment for your business—a specialized computer, say. It’s expected to last three years. At the end of each of the three years, the cash flow from this piece of equipment is estimated at $1,300. You have decided that your required rate of return—the hurdle rate—should be 8 percent. Do you buy this computer or not?

Payback Method

The payback method is probably the simplest way to evaluate the future cash flow from a capital expenditure. It measures the time required for the cash flow from the project to return the original investment—in other words, it tells you how long it will take to get your money back. The payback period obviously has to be shorter than the life of the project; otherwise, there’s no reason to make the investment at all. In our example, you just take the initial investment of $3,000 and divide by the cash flow per year to get the payback period:

Since we know the machine will last three years, the payback period meets the first test: it is shorter than the life of the project. What we have not yet calculated is how much cash the project will return over its entire life.

Right there you can see both the strengths and the weaknesses of the payback method. On the plus side, it is simple to calculate and explain. It provides a quick and easy reality check. If a project you are considering has a payback period that is obviously longer than the life of the project, you probably need to look no further. If it has a quicker payback period, you’re probably justified in doing some more investigation. This is the method often used in meetings to quickly determine whether a project is worth exploring.

On the minus side, the payback method doesn’t tell you much. A company doesn’t want just to break even on an investment, after all; it wants to generate a return. This method doesn’t consider the cash flow beyond breakeven, and it doesn’t give you an overall return. Nor does the method consider the time value of money. The method compares the cash outlay today with projected cash flows tomorrow, but it is really comparing apples to oranges, because dollars today have a different value than dollars down the road.

For these reasons, payback should be used only to compare projects (so that you know which will return the initial investment sooner) or to reject projects (those that will never cover their initial investment). But remember, both numbers used in the calculation are estimates. The art in this is pulling the numbers together—how close can you come to quantifying an unknown?

So the payback method is a rough rule of thumb, not strong financial analysis. If your results with payback look promising, go on to the next method to see whether the investment is really worth making.

Net Present Value Method

The net present value method is more complex than payback, but it’s also more powerful; indeed, it’s usually the finance professional’s first choice for analyzing capital expenditures. The reasons? One, it takes into account the time value of money, discounting future cash flows to obtain their value right now. Two, it considers a business’s cost of capital or other hurdle rate. Three, it provides an answer in today’s dollars, thus allowing you to compare the initial cash outlay with the present value of the return.

How to compute present value? As we mentioned, the actual calculation is usually part of a spreadsheet or template developed by whoever is helping you with the financial side of your company. You can also use a financial calculator, online tools, or the tables found in finance textbooks. But we’ll show you what the actual formula—it’s called the discounting equation—looks like, so you can look “underneath” the result and really know what it means.

The discounting equation looks like this:

where:

PV = present value

FV = projected cash flow for each time period i = discount or hurdle rate n = number of time periods you’re looking at

Net present value is simply equal to present value minus the initial cash outlay.

For the example we mentioned, the calculations would look like this:

and

In words, the total expected cash flow of $3,900 is worth only $3,350 in today’s dollars when discounted at 8 percent. Subtract the initial cash outlay of $3,000, and you get a net present value of $350.

How should you interpret this? If the net present value of a project is greater than zero, it should be accepted, because the return is greater than the company’s hurdle rate. Here, the return of $350 shows you that the project has a return greater than 8 percent.

Sometimes you may want to run an NPV calculation using more than one discount rate. If you do, you’ll see the following relationship:

As the hurdle rate increases, NPV decreases.
As the hurdle rate decreases, NPV increases.

This relationship holds because higher hurdle rates mean a higher opportunity cost for funds. If you set your hurdle rate at 20 percent, it means you’re pretty confident you can get almost that much elsewhere for similar levels of risk. The new investment will have to be pretty darn good for you to decide to pry loose any funds. By contrast, if you can get only 4 percent elsewhere, many new investments may start to look good. Just as the Federal Reserve stimulates the national economy by lowering interest rates, you will tend to invest more if you have a lower hurdle rate. (Of course, it may not be wise policy to do so.)

One drawback of the net present value method is that it can be hard to explain and present to others—your management team, for instance, or your outside investors. Payback is easy to understand, but net present value is a number that’s based on the discounted value of future cash flows. That’s not a phrase that trips easily off the nonfinancial tongue. Still, if you want to use NPV, you should persist. Assuming that the hurdle rate is equal to or greater than your cost of capital, any investment that passes the net present value test will increase the company’s value, and any investment that fails would (if carried out anyway) actually hurt the company and its shareholders.

Another potential drawback—the art of finance, again—is simply that NPV calculations are based on so many estimates and assumptions. The cash flow projections can only be estimated. The initial cost of a project may be hard to pin down. And different hurdle rates, of course, can give you radically different NPV results. Still, the more you understand about the method, the easier it will be to come up with assumptions that make sense. Your understanding of the analysis will allow you to confidently explain why, or why not, you are deciding to make the investment.

Internal Rate of Return Method

Calculating internal rate of return is similar to calculating net present value, but the variable is different. Rather than assuming a particular discount rate and then inspecting the present value of the investment, IRR calculates the actual return provided by the projected cash flows. That rate of return can then be compared with your hurdle rate to see whether the investment passes the test.

In our example, you are proposing to invest $3,000, and your business will receive $1,300 in cash flow at the end of each of the following three years. You can’t just use the gross total cash flow of $3,900 to figure the rate of return because the return is spread out over three years. So we need to do some calculations.

First, here’s another way of looking at IRR: it’s the hurdle rate that makes net present value equal to zero. Remember, we said that as discount rates increase, NPV decreases. If you did NPV calculations using a higher and higher interest rate, you’d find NPV getting smaller and smaller until it finally turned negative, meaning the project no longer passed the hurdle rate. In the preceding example, if you tried 10 percent as the hurdle rate, you’d get an NPV of about $233. If you tried 20 percent, your NPV would be negative, at – $262. So the inflection point, where NPV equals zero, is somewhere between 10 percent and 20 percent. In theory, you could keep narrowing in until you found it. In practice, you can just use a financial calculator or a Web tool, and you will find that the point where NPV equals zero is 14.36 percent. That is the investment’s internal rate of return.

IRR is an easy method to explain and present because it allows for a quick comparison of the project’s return to the hurdle rate. On the downside, it does not quantify the project’s contribution to the overall value of the company, as NPV does. It also does not quantify the effects of an important variable, namely how long the company expects to enjoy the given rate of return. When competing projects have different durations, using IRR exclusively can lead you to favor a quick-payback project with a highpercentage return when you should be investing in longer-payback projects with lower-percentage returns. IRR also does not address the issue of scale. For example, an IRR of 20 percent does not tell you anything about the dollar size of the return. It could be 20 percent of one dollar or 20 percent of one million dollars. NPV, by contrast, does tell you the dollar amount. When the stakes are high, in short, it may make sense to use both IRR and NPV.

COMPARING THE THREE METHODS

We’ve been hinting at two lessons here. One is that the three methods we have reviewed may lead you to make different decisions, depending on which one you rely on. The other is that the net present value method is the best choice when the methods conflict. Let’s take another example and see how the differences play out.

Assume again that you want to invest $3,000 in computer equipment for the business. (Keeping the numbers small makes the calculations easier to follow.) Let’s also imagine that there are three different possible investments in different types of computer systems, as follows:

Investment A: returns cash flow of $1,000 per year for three years
Investment B: returns cash flow of $3,600 at the end of year one
Investment C: returns cash flow of $4,600 at the end of year three

Your required rate of return—the hurdle rate—is 9 percent, and all three investments carry similar levels of risk. If you could select only one of these investments, which would it be?

The payback method tells us how long it will take to get back the initial investment. Assuming the payback occurs at the end of each year, here is how it turns out:

Investment A: three years
Investment B: one year
Investment C: three years

By this method alone, investment B is the clear winner. But if we run the calculations for net present value, here is how they turn out:

Investment A: – $469 (negative!)
Investment B: $303
Investment C: $552

Now investment A is out, and investment C looks like the best choice. What does the internal rate of return method say?

Investment A: 0 percent
Investment B: 20 percent
Investment C: 15.3 percent

Interesting. If we went by IRR alone, we would choose investment B. But the NPV calculation favors C—and that would be the correct decision. As NPV shows us, investment C is worth more in today’s dollars than investment B.

The explanation? While B pays a higher return than C, it only pays that return for one year. With C we get a lower return, but we get it for three years. And three years at 15.3 percent is better than one year at 20 percent. Of course, if you assume you could keep on investing the money at 20 percent, then B would be better—but NPV can’t take into account hypothetical future investments. What it does assume is that your company can go on earning 9 percent on its cash. But even so, if we take the $3,600 that investment B gives us at the end of year one and reinvest it at 9 percent, we still end up with less at the end of year three than we would get from investment C.

So it always makes sense to use NPV calculations for your investment decisions, even if you sometimes decide to use one of the other methods for discussion and presentation. But again, the most important step a business owner can take when analyzing capital expenditures is to revisit the cash flow estimates themselves. They are where the art of finance really comes into play and where entrepreneurs can make their biggest mistakes. Often it makes sense to do a sensitivity analysis—that is, check the calculations using future cash flows that are 80 percent or 90 percent of the original projections, and see whether the investment still makes sense. If it does, you can be more confident that your calculations are leading you to the right decision.

This chapter, we know, has involved a lot of calculating. But sometimes you’d be surprised at how intuitive the whole process can be. Not long ago, Joe was running a financial review meeting at Setpoint. A senior manager in the company was suggesting that Setpoint invest $80,000 in a new machining center so that it could produce certain parts in-house rather than relying on an outside vendor. Joe wasn’t wild about the proposal for several reasons, but before he could speak up, a shop assembly technician asked the manager the following questions:

Did you figure out the monthly cash flow return we will get on this new equipment? Eighty thousand dollars is a lot of money!
Do you realize that we are in the spring and that the business is typically slow, and cash is tight, during the summer?
Have you figured in the cost of labor to run the machine? We are all pretty busy in the shop; you will probably have to hire someone to run this equipment.
Are there better ways we could spend that cash to grow the business?

After this grilling, the manager dropped the proposal. The assembly technician might not have been an expert in net present value calculations, but he sure understood the concepts.