01 March 2005

How to make a good capital decision

By Scott Peterson and Doug Post

Information is the feedstock of good decisions. Your job is to provide great information to your company's decision makers. The following methodology should help decision makers produce good capital decisions. It will also help decision makers educate and develop other employees on capital purchases.

1. Articulate "The Why" or purpose of every capital purchase. (e.g. increase capacity, improve quality, grow profits). If the capital purchase is a significant purchase for the company, then this section should include current status of the industry, benchmarks, and projected industry trends. Also, the business risk, which is the risk associated with operating the new asset, should also be identified.

2. Identify the initial costs of the project, including set-up fees, and how it will be funded (e.g. from operating cash flows, borrowing, etc.). If you are going to finance a large capital purchase, then you should analyze pro forma financial statements to ensure you would meet all current debt covenants. Financing increases the risk borne by stockholders and usually leads to a higher expected rate of return on equity.

3. Ascertain the additional revenues and expenses, including depreciation, taxes, and interest. Since interest expense is tax deductible, this lowers the real cost of debt or the effective interest rate. (i.e. the effective cost of debt = interest rate – {interest rate * tax rate}).

4. Determine (from the above information) future cash flows of the project by month or year. These cash flows normally extend out for only five years for small and medium size purchases. For large-scale new production projects, cash flows can extend out up to 15 years.

5. Determine the risk of the project by estimating the probability of future cash flow. Risk reflects the chance the estimated cash flows or return will be different than the actual cash flows or return. Many people skip this step, since it is the most ambiguous element of the model. However, it is better to estimate the risk of the projected cash flows instead of ignoring it. At a minimum, you should assign your company's line of credit interest rate for very low risk projects and designate the best market returns for high-risk projects. Once calculated, this percentage is used to discount the cash flows. The financial flexibility of the company should also be considered, since this represents the ability of the company to raise capital (funds) on reasonable terms under adverse conditions.

6. Choose an analysis tool. This could vary from the simple payback method (i.e. how long it takes to recover the initial costs) to net present value, which considers the additional cash flows (positive and negative), while considering the time value of money. The following is a list of several analysis tools:

• The payback period is the simplest and quickest method. It uses the estimated cash flows to determine how long it takes to recapture the original investment. This method stresses liquidity. However, payback period ignores the time value of money and the cash in-flows once you recovered the original investment. It also favors short-term projects.
• Return on Assets (ROA), Return on Equity (ROE), and Return on Investment (ROI) focus on the efficiency of the investment. Since none is inherently better than another and the tools use different reference points, you should choose the one that your company is most comfortable with.
• Net Present Value (NPV) is the present value of cash flows less the original investment. This is the best tool, since it always gives an objective and correct answer.
• Profitability Index (PI) divides the net present value of the cash in-flows by the initial investment. This method determines the return per dollar invested, thus, allowing you to compare projects of various sizes. The method is good for ranking mutually exclusive projects or when firms need to ration their capital expenditures.

7. Make a recommendation. Provide pros and cons of the project, identify externalities or intangibles, and attach supporting information.

Capital decisions are extremely important to the financial success of your company. Through implementing this methodology, decision makers can elevate the company's performance and be a good fiduciary or steward of the company's assets.

Behind the byline

Scott Peterson is chief financial officer and Doug Post is president of Interstates, a sister company of Interstates Control Systems, a registered member of Control and Information System Integrators Association (CSIA). You can reach Post at (712) 722-1662 x159, or doug.post@interstates.com.