Capital Expenditure Decisions for Your Small Business
by Steve Studer, EVP/Chief Credit Officer, Scott Valley Bank
Capital spending (“Capex”) for a small business is one of the more important long-term decisions that entrepreneurs face. This article focuses on analytical disciplines that can help quantify the expected outcomes and improve the success of the project long term.
When businesses commit capital to long term expansion projects during a sluggish economy, they are demonstrating a certain level of confidence in the future. The current business investment statistics (equipment and software spending) demonstrate a somewhat surprising result based on information from the last several quarters. While equipment and software spending are not off the chart, they seem to reflect that business capital spending in the current economy is proceeding at a pace at least similar to many other economic recovery periods. Statistics related to capital spending are difficult (at least for non economist types) to glean from the significant amount of data available on this economy. However, the GDP calculations contain line item accounts under Private Domestic Investment for equipment and software purchases. Since the first quarter of 2010, every successive quarter, save one, has shown positive growth on an annualized basis in private equipment spending--some quarters were even significantly strong. The last two quarters, however, do show some signs of slowdown. Orders for non defense durable goods, a measurement of future business investment in capital assets, did show a decline in July, possibly signifying some slow down in this sector. However, business capital spending does have a significant impact on the overall level of GDP in this economy--even stronger than residential construction.
Despite the positive statistics just quoted, most anecdotal evidence indicates that small businesses are expanding at a very slow pace, and making those larger Capex expansion decisions much more cautiously than in the past. Expansionary Capex in this challenging economy needs to be managed much more judiciously to ensure that outcomes achieve the positive impact desired.
Business managers must develop a consistent and realistic framework to rank potential Capex projects. Key to the analysis of any Capex decision and a true starting point is the full understanding of the future expected cash flows of the investment. Managers need to have a clear, well-detailed and time-lined income and expense calculation of the expected results of the project. After all, these investment decisions have, as their most basic principle, the economic advancement of the business and the wealth of the shareholders/owners. Expected revenue enhancements need to be thorough and weighed against all new expenses. Ultimately, the net cash flow impact of the investment decision needs to be calculated and structured over the most realistic time horizon.
Not all Capex decisions involve revenue enhancement exclusively. Many have a much higher impact on expense reductions, such as the employment of newer technologies that reduce employee costs. The tax impact of capital spending will also impact the cash flows. CPAs can help in determining the impact of the after tax cash flows of putting new equipment to work. Depreciation expense, interest expense and possible tax credits are all major factors entering into the decision.
Once the after-tax net cash flow impact has been constructed, tested and supported, those numbers should be run through an analytical matrix to measure the impact of those cash flows cumulatively and over time. A couple of tried and true methods are as follows:
Payback Period: How long does it take to get the initial investment costs back through the accumulation of the hopefully positive net cash flows? This is a fairly simple yet effective method to measure a time component result. The longer the time horizon, the greater the risk and the lower the return. If it takes you 84 months to get your investment back on equipment you expect will only be functioning for 60 months, the risk and value of that decision should be clear.
Hurdle Rate: This process involves setting a return hurdle rate by measuring the time value of the future cash flows against a set expected return level. Higher return rates should be set for higher risk projects. If the project exceeds the set hurdle rate, the project passes.
IRR and NPV –(Internal Rate of Return and Net Present Value): These are clumped together since they utilize the same calculations – time value of money. Future cash flows expected from the Capex decision are discounted back to the date of the initial investment. Under IRR, the rate of return of the investment is calculated for the return of cash flows over time against the initial cash outlay of the investment. NPV calculates the present value of the future cash flows in today’s dollars at the firm’s cost of capital (a pre-established rate of return), and bounces that net present value off of the initial investment cost. If the NPV of future cash flows discounted at the firm's cost of capital is higher than the initial investment, the project succeeds, or at least should be considered further. The time value of money concept is a simple one (but difficult to calculate without a business calculator) in that $1,000 today is more valuable to you than $1,000 in one year, since you can invest that money for a year and make some level of return.
All of these methods might sound complex and onerous to most small business owners. However, if you and your internal staff do not have the expertise, your accountant and banker can help orient these analytical pieces into some kind of framework for you. Bad Capex decisions are too costly not to seek out help from your support network. This economy is especially unforgiving on bad Capex decisions.
Once the decision has passed the return test and cash flows are analyzed and well supported, you may need financing. One basic finance premise we all grew up with is “don’t pay for capital assets with short term funds.” Longer term assets should be structured with longer term financing to preserve liquidity and provide a stronger cushion for your short term working capital needs. Unless you are awash in liquidity that cannot be deployed elsewhere in the business, you should consider some kind of term financing for the project. Your banker can help here.
Banks are anxious to deploy their liquidity into well-structured loans to well-run businesses for Capex decisions that come with the level of analysis we have just described. Walk into your banker’s office with a detailed set of cash flows and an IRR analysis for your next Capex project and you will be surprised at his/her excitement. The business must support the borrowings with existing or projected cash flows. If it is not employing positive cash flowing Capex investments, the business is only cannibalizing the existing earnings of the business and likely not returning enough to ownership in its investment planning.
Leasing provides other financing options for the business owner. If you do not need the depreciation and other tax benefits of owning the equipment, you might be better off leasing equipment. However, this is another team decision that your CPAs and Bankers can help with.
In summary, Capex spending is a bet on the future. With today’s challenges you cannot afford to risk the company’s scarce capital on inadequately detailed and analyzed project spending. Your centers of influence (i.e. CPA’s and Bankers) thrive on assisting with your strong Capex decisions that will allow you to be a positive part of our GDP growth for the next quarter and beyond.