Capital investments need a well-planned ROI in place

Prior to my involvement with digital fabrication technology, I was a consultant for 25 years valuing investment-grade real estate and medium-sized businesses. Though most of this was enjoyable, the most distressing part was trying to save a business from insolvency or, worse, valuing the remains of an insolvent business.

I found that most businesses and real estate projects in financial distress were due to poorly conceived and executed business plans. Four scenarios often occurred:

The business plan contained overly optimistic expectations. Income estimates were too high or projected as being realized too quickly and expense estimates were too low.

The business plan had inadequate support for the income and expense estimates; commonly known as “heroic assumptions.”

There was under-capitalization.

There was a lack of downside planning if expectations were not being met.

These bad business plans shared another common deficiency: choosing the wrong return-on-investment tool to analyze a capital equipment purchase, such as a CNC router and its ancillary hardware and software, and users not clearly understanding the financial measurement tools being used.

There are several different investment tools in common use. This makes it is a necessity for the shop owner and everyone involved with a capital equipment purchase to define the financial measurement tools in the same way. Further, the financial measurement tools should also be used on a pre-income tax and pre-depreciation basis. To use assumptions of income tax savings to pay for a capital tool purchase is not a prudent business practice.

Here are the most common methods to measure the financial performance of a capital-tool investment:

Return on investment

ROI is a very simple tool that makes explicit the estimated direct gross income, direct costs and expenses of a capital tool purchase.

To calculate ROI, the benefit or net return of a capital equipment investment is divided by the cost of the investment. The result is expressed as a percentage or a ratio.

A ROI should be calculated with and without loan payments — both principal and interest — as direct expenses and must be done on a pre-income tax basis.

Payback period

Payback period is the number of years it takes for a company to recover its original investment in a capital equipment investment. In the calculation of the payback period, the estimated annual net income derived from the equipment must first be derived.

To calculate, payback period equals:

There is another version of this method that adds in what the owner contributed to the purchase price, also known as the equity in the deal. Both methods should be used since they tell the owner how many months it will take before the estimated annual net income finally goes to the net operating income of the business, rather than to loan payoff and equity payback.

Net present value

Both of the previous financial measurement tools assume that money earned in the future has the same value as money earned today. Any woodshop owner knows when he is told, “I will pay you in a week or so,” there is risk involved in collecting that amount. Also labor, materials and overhead costs to complete the job will have to come from another source. Banks charge interest for this service.

Calculating the net present value for capital equipment purchase is a more sophisticated method of making an investment decision. It takes into account the timing of the expenditures and receipts of income generated by the new tool. It is based on the assumption that money due in the future does not have the same value or purchasing power as money due today.

Calculations made with time-value-of-money methods use an interest rate known as the discount rate and the explicit understanding that the total amount invested provide a specified return.

Determining the return or discount rate is based on numerous factors, including the cost of borrowed money; the historic rate of return earned on similar investments; returns others have experienced on competing similar and non-similar investments; the amount of risk involved; and the period of time over which the money is to be earned, which is known as the discount period.

The result of a net present value calculation is a dollar amount representing the present value of all direct costs and expenses and projected gross income directly attributed to the capital equipment during a given period of time. The amount should at least equal, though preferably exceed, the original cost of the capital equipment as installed and operating.

Internal rate of return

This is related to net present value and matches the timing of cash flows, which are receipts and expenditures during a given period of time. The difference is there is no chosen discount rate. Instead, the return is calculated with a net present value of zero, indicating the present value of receipts and expenditures are equal.

There isn’t a “best” financial planning and measurement tool since they all have strengths and weaknesses. And, most importantly, they all have underlying assumptions concerning the estimated income and expenses used in the calculations and for how the financial tools operate. These assumptions need to be made explicit and must be clearly understood by all involved so decisions based on the results of these financial tools can be placed in a context. Failure to do so can have unexpected and catastrophic results.

This article originally appeared in the April 2015 issue.