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FIGURING “RETURN ON INVESTMENT” (ROI)
Analyzing Capital Expenditures
The following example is taken from FINANCIAL INTELLIGENCE by Karen Berman & Joe Knight. Harvard Business School Press, 2006. (If you are not familiar with this book, you might consider adding it to your personal library. I find myself referring to it over and over again. )
Example:
Your company is considering purchasing a $3,000 piece of equipment—a computer for example.
Its useful life is expected to be 3 years.
At the end of each of the three years the expected cash flow is estimated to be $1,300.
Your company’s required rate of return—the hurdle rate—is 8 percent.
Do you buy the computer or not?
PAYBACK METHOD
Initial Investment/Cash Flow per Year
$3,000/$1,300 = 2.31 Years
The payback period is shorter than the life of the asset. It passes the first test.
NET PRESENT VALUE
The ‘discounting equation’ looks like this…
PV = FV1/(1+i) + FV2/(1+I)(1+i) + FV3/(1+i)(1+i)(1+i)
PV = $1,300/1.08 + $1,300/(1.08)(1.08) +$1,300/(1.08)(1.08)(1.08)
PV = $1,300/1.08 + $1,300/1.17 +$1,300/1.26
PV = $1203.70 + $1,111.11 + $1031.75
PV = $3346.56 or $3347 rounded
The anticipated future cash flows of $3900 are worth only $3346.56 in today’s dollars at 8%.
If you subtract the original investment of $3,000 you get a net present value of $347.
If the net present value is greater than zero you should buy the computer because it exceeds the company’s hurdle rate of 8%. It passes the second test.
INTERNAL RATE OF RETURN
Internal Rate of Return (IRR) is the rate at which the net present value (NPV) of future cash flows will equal zero. In other words it is the rate where the future cash flows when discounted at some rate will equal the original investment.
Using a financial calculator or web tool you find that the IRR for this example is 14.36%.
When compared to the hurdle rate of 8%, the IRR of 14.36% is greater so you should buy the computer. It passes the third test.
COMPARING THE THREE METHODS
Two things to always remember when comparing the three methods…
•
The three methods may lead you to making different decisions
The three methods may lead you to making different decisions•The Net Present Value method is the best choice when the methods conflict
The Net Present Value method is the best choice when the methods conflictExample:
Your company has $3,000 to invest.
There are three different possible investments to consider.
•Investment A: Returns cash flow of $1,000 per year for three years
Investment A: Returns cash flow of $1,000 per year for three years•Investment B: Returns cash flow of $3,600 at the end of year one
Investment B: Returns cash flow of $3,600 at the end of year one•Investment C: Returns cash flow of $4,600 at the end of year three
Investment C: Returns cash flow of $4,600 at the end of year threeThe required rate of return—the hurdle rate—is 9%.
All investments carry equal risk.
You can select only one of the investments—which one will it be?
USING THE PAYBACK METHOD
•Investment A: three years
Investment A: three years•Investment B: one year
Investment B: one year•Investment C; three years
Investment C; three yearsInvestment B would be the choice.
USING THE NET PRESENT VALUE METHOD
•Investment A: ($469)
Investment A: ($469)•Investment B: $303
Investment B: $303•Investment C: $552
Investment C: $552Investment C would be the choice.
USING THE INTERNAL RATE OF RETURN METHOD
•Investment A: 0 percent
Investment A: 0 percent•Investment B: 20%
Investment B: 20%•Investment C: 15.3%
Investment C: 15.3%Investment B would be the choice.
WHY SHOULD WE CHOOSE INVESTMENT C?
Investment C is worth more in today’s dollars than the other investments.
Capital considerations are the foundation of many financial decisions made in corporate America today. Decisions have consequences. Whenever you decide on a certain course of action you have to give up something in order to pursue your objective. The phrase used to explain this concept is Opportunity Cost. For example, if you decide to spend your money on a new car, what you give up is the availability of spending that money on something else. Something is gained, the new car, but something is lost in the process, the chance to use those funds elsewhere. In Business, Opportunity Costs, refer to the benefits you forfeit when you make decisions that do not result in the optimum financial return.
The three (3) essential factors in Capital Considerations are:
• Figuring RETURN ON INVESTMENT (ROI)
• Understanding DEPRECIATION
• RISK vs. REWARD
One definition is paramount in Capital Considerations. When deciding whether or not an investment is worthwhile for the business, or even when trying to decide between two or more investment alternatives, decision makers take into account the concept of ‘the Required Rate of Return’. The Required Rate of Return is known as THE HURDLE RATE. Different companies have different requirements and expectations on what constitutes a worthwhile investment for them. Do they want to make 12% on their investment or can they live with an 8% return? The lowest return a business is willing to make on risking their capital is THE HURDLE RATE. It is the ‘bar’ or ‘the hurdle’ they have to get over before an investment makes sense. Think of it as a ‘comparison rate’. You compare what you think you can make on future investments to your hurdle rate. If the anticipated return is greater than the hurdle rate, the business should make the investment. If not, pass it by. Exhibiting good judgment is crucial in the process. The more accurately you can predict an investment’s benefit, the better decisions you will make. The following information will help you do just that.
CAPITAL
CONSIDERATIONS
How much is your business costing you?
A QUESTION TO CONSIDER...
Figuring Return on Investment (ROI)
Understanding Depreciation
DEPRECIATION
Capital Expenditures vs. Operating Expenses
Accountants must determine if a given cost is a capital expenditure or an operating cost. There are several differences and the accountant’s decision may affect the business’s Bottom Line profitability immediately. (Remember that Depreciation spreads the cost of a physical asset over its lifetime.)
•Capital expenditures allocate the cost over several accounting periods, while operating expenses are generally accounted for in one accounting period.
Capital expenditures allocate the cost over several accounting periods, while operating expenses are generally accounted for in one accounting period.•Operating expenses are found on the INCOME STATEMENT, capital expenditures are included on the BALANCE SHEET. (For this reason operating expenses reduce Profit and capital expenditures affect Total Assets.)
Operating expenses are found on the INCOME STATEMENT, capital expenditures are included on the BALANCE SHEET. (For this reason operating expenses reduce Profit and capital expenditures affect Total Assets.)•Depreciation is considered by accountants to be a Noncash Expense. A noncash expense is an expense that is reflected on the INCOME STATEMENT, but is not actually paid out in cash. Depreciation is a prime example, because accountants spread the cost of the physical asset over its lifetime, thus covering several accounting periods, even if the asset was acquired in a previous accounting period.
Depreciation is considered by accountants to be a Noncash Expense. A noncash expense is an expense that is reflected on the INCOME STATEMENT, but is not actually paid out in cash. Depreciation is a prime example, because accountants spread the cost of the physical asset over its lifetime, thus covering several accounting periods, even if the asset was acquired in a previous accounting period.TWO METHODS OF DETERMINING DEPRECIATION
STRAIGHT LINE DEPRECIATION
If the cost of an asset is spread over its lifetime equally, accountants use a method known as STRAIGH LINE DEPRECIATION. The formula for Straight Line Depreciation is:
Depreciation = Asset Cost less Salvage Value / Useful LifeSeveral accounting terms need definition to understand the formula: 1) Useful Life 2) Salvage Value, and 3) Operational Life.
•Useful Life is a term that defines the number of years that the federal government will give a tax deduction for depreciating an asset. (They usually will specify a time frame per asset class, and accountants are free to choose the most appropriate date, within the given time frame, that reflects the company’s use of the asset.)
Useful Life is a term that defines the number of years that the federal government will give a tax deduction for depreciating an asset. (They usually will specify a time frame per asset class, and accountants are free to choose the most appropriate date, within the given time frame, that reflects the company’s use of the asset.)•Operational Life is the number of years that a physical asset should last in actual operation.
Operational Life is the number of years that a physical asset should last in actual operation.•Salvage Value is the estimated market value of a physical asset at the end of its Useful Life.
Salvage Value is the estimated market value of a physical asset at the end of its Useful Life. Since Salvage Value is an estimation of an asset’s market value at the end of its Useful Life, it is extremely hard to determine, particularly in today’s fast changing economic climate. For this reason it is not uncommon for accountants to estimate the Salvage Value of a physical asset to be zero ( 0 ). By doing so, the formula for Straight Line Depreciation becomes simply:
Asset Cost / Useful Life
If the asset is sold subsequent to the end of its Useful Life, the accountant will make an Adjusting Entry to correct the depreciation taken to date. It can greatly simplify the process for accountants and more accurately depict the valuation of the asset.
ACCELERATED DEPRECIATION
If the cost of a physical asset is accounted for more heavily toward the beginning, rather than the end, of its lifetime, accountants use a method known as ACCELERATED DEPRECIATION. This results in more depreciation expense being taken in the earlier years with less depreciation expense taken in the latter years. Accelerated Depreciation may more accurately depict the market value of a physical asset.
There are two primary means of determining Accelerated Depreciation: 1) Using Declining Balances, and 2) Using Sum of the Years Digits.
DECLINING BALANCES
Using Declining Balances simply means multiplying the asset’s net book value by a rate that represents a specified percentage of the Straight Line Method. The most commonly used Declining Balances are:
•150 Percent Declining Balance
150 Percent Declining Balance•175 Percent Declining Balance
175 Percent Declining Balance•200 Percent Declining Balance
200 Percent Declining BalanceSUM OF THE YEARS DIGITS
Using the Sum of the Years Digits is somewhat involved, but it does, however, accomplish its objective of accelerating the depreciation expense taken.
The Sum of the Years Digits takes the asset’s cost, less salvage, and multiplies it by a fraction using the sum of the digits of the Useful Life as the denominator. (For example if the useful life of a physical asset is 5 years, the sum of the digits used would be 1+2+3+4+5 = 15). The numerator is each individual year taken in reverse order. So the fraction used in the first year is 5/15. Multiplying the asset cost, less salvage, by 5/15, results in the first year’s depreciation expense. (The second year would be multiplied by 4/15.)
PLEASE NOTE!Many organizations elect the Straight Line Method of Depreciation for calculating depreciation expense.
Many organizations elect the Straight Line Method of Depreciation for calculating depreciation expense. - It tends to provide a more clearly defined audit trail.
- It simplifies the process, and
- It will not reduce net income as greatly in the earlier years. (A Fact Investors and Stockholders appreciate.
Risk vs. Reward
RISK vs. REWARD
Viability vs. Profitability
VIABILITY
Financial viability is measured in terms of LIQUIDITY and SOLVENCY.
Liquidity to accountants is the ability of the business to convert its CURRENT ASSETS into Cash. “Current” in Accounting and Finance is “Less Than One Year”. So, therefore, Current Assets are those physical assets that can be turned into cash in less than one year. If a business has enough Current Assets to meet its current obligations it is said to be “LIQUID”.
Solvency is exactly the same concept, except it extends over a longer period of time. One year or longer in duration to an accountant is said to be “Fixed” or “Long Term”. To measure the ability a business has of meeting its Long Term Obligations, accountants will compare Total Assets to Total Liabilities. The extent to which Total Assets exceed Total Liabilities gives accountants an indication of how ‘viable’ a business truly is over the longer term, say five to ten years. A good way to think of Viability is in terms of survival. Does a business have enough cash and available assets to weather the economic storms to come?
PLEASE NOTE! Liquidity problems, which eventually lead to business failure, are often created by inadequate Liquidity and Solvency Planning in the formative years of the business.
PROFITABILITY
Given the above emphasis on Viability, you might think that it would be good business strategy to maximize a company’s Liquidity and Solvency. Unfortunately, it is not that easy. There is a problem with “Too Much Liquidity”! Every dollar that is reserved in Cash or Cash Equivalents (Current Assets that can be converted into Cash quickly, usually within 24 hours), is a dollar that cannot be invested in a longer term, higher return type of investment. The more Profitability a business seeks, the less Liquidity it can maintain, and therefore, the higher the possibility of a liquidity crisis and ultimate bankruptcy; and business failure. The more Liquidity a business retains, the less profit margin it can generate.
The ‘Balancing Act’ for a business is the tradeoff between Viability & Profitability. A business must always ask the question, “How much Cash is enough?”
One thing should never be forgotten. A positive Bottom Line on the INCOME STATEMENT, which means the business is making a Profit, is not an indication that the company is healthy. Profitability is never a guarantee of business success or even survival. The numbers mentioned on the HOME PAGE clearly illustrate that each and every year most businesses fail, at some point in their existence. Many were able to show a Profit when they did. What caused the problems and ultimate downfall of the business? They simply did not have enough Cash to stay in business. Lou Mobley, of IBM fame, noted that “they grew broke!” He went on to say that “You can operate a long time without Profit, but you can’t survive one day without Cash.”
ALWAYS REMEMBER: PROFIT IS NOT CASH! A Business Needs Both to Survive.
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