Small Business Taxes & ManagementTM--Copyright 2010, A/N Group, Inc.
In tough economic times it's difficult to know whether or not to commit to capital expenditures, particularly those involving the expansion of your business. Many business owners use their intuition; some use an even less rational approach. There are more scientific approaches available without getting too technical.
No Analysis Needed
There are some situations where no analysis is needed. One of your two printers dies. A rough estimate of the cost to repair is more than the cost of a new machine. Can you get along with only one? Maybe, but if that fails, you'll have to run out for a new one. Moreover, running with one printer means that they'll be a number of times during the day when someone is waiting for a job to print. Clearly, a replacement is needed.
No analysis is usually needed if:
Depending on your line of business, there are sure to be additional situations where there's no need to do the math. The last item above refers to substantial cost savings. Generally, you should look at the numbers carefully before making a decision based on this criteria. But sometimes, particularly with changes in technology, the savings are patently obvious. But don't automatically replace the equipment just because it's failed. You may no longer need the unit because your business or the technology has changed.
There are several ways to analyze the purchase of a piece of equipment. If you took any finance course in college, you probably remember the phrase "net present value". We won't go into to details here, but the basic approach is to apply a factor, equal to the firm's cost of capital, to the periodic (generally annual) cash flows from the project. Under this approach early returns from the project are more valuable than later returns. There are variations on the approach, but the concept remains pretty much the same.
The net present value approach (or one of the variations) is generally the best approach to analyze an investment. All cash flows accounted for, including any salvage value at the end of the project and negative cash flows (e.g., high repair costs in the 5th year of the project). The problem is that the method is not so easy to use in practice, particularly by a small business. Two of the biggest problems is finding the appropriate discount rate and applying risk analysis to account for the uncertainty of the cash flows. Moreover, the cost of the analysis for small projects may outweigh any savings. But for costly and long lived projects, a net present value analysis is certainly preferable.
The payback period has long been used for a quick and cheap (and dirty) analysis. In the current economic times it can make sense since it inherently takes into account risk and particularly the risk associated with risk several years out. It can be very useful for investments in fast changing technology. For example, a piece of equipment that may be obsolete or where a significant upgrade should be available in a couple of years. However, that doesn't mean you don't need to have a handle on the cash flows from the investment.
Here's how it works. Project the net cash flows from the project. Then determine how many years it takes to recover your cash outlay. An example should make it clear.
Example--Madison LLC is considering the replacement of a machine used on the shop floor. The machine will cost $34,000 and will save $16,000 the first year and 18,000 the second year because the operator can perform another task at the same. Because of lower maintenance, the machine is expected to save $24,000 in the third and fourth years. No projections were made for later years. Here's the analysis:This simple example brings out several points. First, we don't care what happens in year 3 (or later). Madison recovers its cost in two years. That's a plus. Projecting cash flows for 2 years should be easy. The further out the projection, the more difficult it becomes. But there's a negative. We don't care what happens in year 3 (or later). In the example above the cash flow in years 3 and 4 is $24,000. What if the cash flow in those years was only $1 each. We would recover our investment, but we'd just break even on the outlay. The idea is to recover more than our investment. Worse, what if in year 3 we have to do expensive repairs so the machine will still operate in year 4?Cost Cash Inflow Cash Inflow Cash Inflow Cash Inflow Year 1 Year 2 Year 3 Year 4 $34,000 $16,000 $18,000 $24,000 $24,000The payback period, the time to recover your investment, is 2 years ($16,000 plus $18,000 equals $34,000). (If the machine had cost $36,000, the payback period would be 2 years, 1 month (cash flow in year 3 is $2,000 per month)). Thus, as long as the machine can keep working, the demand for its output remains, and the savings remain the same for two years, Madison will recover its costs in that time.
The payback period suffers drawbacks when comparing projects or investments. That's because it doesn't factor in the time value of money or cash inflow (or outflow) after the payback period. We'll use the same basic example as above, but modify the cash inflow (outflow) numbers.
Example--The equipment cost is the same as in the example above. The cash inflows for project B, C, D and E are different:Project Cost Cash Inflow Cash Inflow Cash Inflow Cash Inflow Year 1 Year 2 Year 3 Year 4 A $34,000 $16,000 $18,000 $24,000 $24,000 B 34,000 0 34,000 24,000 24,000 C 34,000 16,000 18,000 90,000 1,000 D 34,000 16,000 18,000 -20,000 25,000 E 34,000 34,000 5,000 5,000 5,000We already agreed that project A (the original) had a 2-year payback period. But so do projects B, C, and D. Project B though, has the disadvantage that there's no cash in year 1; all the cash inflow is in year two. That makes it a little riskier and because of the time value of money we'd prefer to get our return upfront, or at least spread equally over the period.
Project C is probably the best of the first four because, in addition to getting our investment back in two years, we'll get $90,000 in year 3. With project A and B we only get $24,000 for each of years 3 and 4. However, using a strict payback approach, we'd accept any of the first four projects.
Project D has a cash outflow in year 3 (the machine will need repair). In fact, the return in excess of Madison's investment for the four years is only $5,000 ($39,000 cash inflow less $34,000 investment), the lowest of any of the projects.
Project E is slightly different. It's payback period is only 1 year. The drawback is the cash flows after the payback period are only $15,000. That's much less than in projects A, B, or C.
Which project would you pick given the information above? The payback period for D is one year, but project C probably makes the most sense. It's got a 2-year payback period and cash flows after the payback are larger than for any of the other projects.
Adding Complexity Deciding Between Multiple Choices
The example above emphasized whether or not the project would return your outlay in two years. All the projects met that criteria. And many times that's the threshold that must be met. That is, the economic environment is uncertain, technology is likely to change, and the company is strapped for cash. Only projects that have a payback period of 2 (or some other number) years or less will be funded. That's the typical situation where the payback period is used.
But what if you're trying to decide between two or more projects? For example, machine A costs $20,000 and should last 4 years and produce certain dollar savings. Machine B costs $30,000, will last 5 years and produce more savings. Here both machines may have the same payback period, but machine B will produce more cash flow over its projected life.
There are two ways to look at this problem. The first is the simplistic. Go with the cheapest unit that meets the payback criteria. Makes sense if the project is real risky. If not, go with the second choice, the one that meets your payback period criteria and produces the most overall cash flow.
We can create a method for solving several of these problems without adding complexity. First analyze the investment using the payback method. If it meets your criteria, say payback in 3 years, then compute the raw return on investment by dividing the total expected return, taking into account positive and negative cash flows after the initial investment by the investment. If the number is greater than one, you can accept the investment. If you're comparing two or more investments that meet the payback criteria, select the one with the larger return on investment.
Example 1--Madison is considering a new machine costing $20,000. The cash returns are $9,000 in year 1, $11,000 in year 2, negative $7,000 in year 3 and positive $3,000 in year 4. If Madison's threshold is a 2-year payback, the machine meets the test ($9,000 in year 1 plus $11,000 in year 2). Now compute the return on investment ratio. The total return is $16,000 ($9,000 + $11,000 - $7,000 + $3,000). Divide that by the cost of the investment ($20,000) and the ratio is 0.8. Since that's less than one, you should reject the investment despite meeting the payback period test.
Example 2--Assume the same facts as in Example 1, but the return in year 4 is $8,000. Now the total return is $21,000. The return on investment is 1.05 (or 5%). Since the number is greater than 1, accept the investment.
Example 3--Madison is considering two different machines. The first costs $20,000 and has returns of $9,000, $11,000, $4,000, and $5,000. The second costs $40,000 and has returns of $15,000, $25,000, $12,000 and $15,000. Both machines have a payback period of exactly 2 years. But the raw return on investment on the first machine is 1.45 ($29,000/$20,000) or 45%. The return on the second machine is 1.675 (67.5%). Thus, using the return on investment criteria, the second machine is the better choice. However, considering the second machine is twice as expensive, if uncertainty is high, you might decide to stick with the first simply because the lower cost means less risk if the returns don't turn out as expected.
As we said in the opening, the payback period is not a very scientific approach and has a number of drawbacks. Adding the return on investment only reduces some of those drawbacks. The advantage is that risk is taken into account and, in many cases, the payback period is the only analysis needed and the calculations are simple.
In the examples above the numbers we used were to make illustration easier. Depending on the size of your firm and other factors, you might decide to use a more rigorous analysis when the cash outlay exceeds, say $20,000.
Keep in mind that the raw return on investment is simply an overall return. It's not an annual return and it doesn't take into account compounding. In Example 3 above, the 45% return is over a 4-year period. Thus, the annual return would be closer to 10%.
Finally, we should mention one refinement that's sometimes used. That's discounting the cash flows to arrive at the payback period. Discounting takes into account the time value of money. Thus, a $10,000 payment received in year 1 is worth more than a $10,000 payment received in year two. This may or may not improve your analysis and it does add complexity.
Copyright 2010 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. The information is not necessarily a complete summary of all materials on the subject. Copyright is not claimed on material from U.S. Government sources.--ISSN 1089-1536
--Last Update 08/30/10