A STEP-BY-STEP GUIDE TO ANALYZING CAPITAL EXPENDITURES
You’ve been talking with your banker about getting a loan for a new piece of equipment for the plant, or maybe for a new marketing campaign. He’s receptive, but he wants more data. “Sounds good,” he says. “Write me up an ROI analysis. I’ll look at it as soon as it’s ready.”
Don’t panic. Here’s a step-by-step guide to preparing your proposal:
- Remember that ROI means return on investment—just another way of saying, “Prepare an analysis of this capital expenditure.” The banker wants to know whether the investment will generate enough cash so that you can pay back the loan and still create value for your company.
- Collect all the data you can about the cost of the investment. In the case of a new machine, total costs would include the purchase price, shipping costs, installation, factory downtime, debugging, and so on. Note where you must make estimates. Treat the total as your initial cash outlay. You will also need to determine the machine’s useful life, not an easy task (but part of the art we enjoy so much!). You might talk to the manufacturer and to others who have purchased the equipment to help you answer that question.
- Determine the benefits of the new investment, in terms of what it will save the company or what it will help the company earn. A calculation for a new machine should include any cost savings from greater output speed, less rework, a reduction in the number of people required to operate the equipment, increased sales because customers are happier, and so on. The tricky part here is that you need to figure out how all these factors translate into an estimate of cash flow. Don’t be afraid to ask for help from your accountant or financial adviser. Many finance professionals have been trained in this kind of thing, and they should be willing to help.
- If you have determined a hurdle rate for your company, calculate the net present value of the project using this hurdle rate. If you haven’t yet established a rate, decide on one. (It obviously needs to be higher than the interest rate on the loan you are applying for.)
- Calculate payback and internal rate of return as well. You may get questions about what they are from your banker, so you need to have the answers ready.
- Write up the proposal. Keep it brief. Describe the project, outline the costs and benefits (both financial and otherwise), and describe the risks. Discuss how it fits with your company’s strategy or competitive situation. Include your NPV, payback, and IRR calculations in case there are questions about how you arrived at your results.
Business owners sometimes go overboard in writing up capital expenditure analyses. It’s probably human nature: we all like new things, and it’s usually pretty easy to make the numbers turn out so that the investment looks good. But we advise conservatism and caution. Explain exactly where you think the estimates are good and where you think they may be shaky. Do a sensitivity analysis, and show (if you can) that the estimate makes sense even if cash flows don’t materialize at quite the level you hope. A conservative proposal is one that is likely to fly—and one that is likely to add the most to the company’s value in the long run.