Most businesses discover quite early on that the equipment, machinery, space, etc that they started up with is not adequate for their future needs. That does not necessarily make the owners bad businesspeople; it just shows how difficult it is to predict the future shape of any business. Perhaps they prudently chose second-hand items, or they were extremely conservative in their sales forecasts, and now simply cannot meet the demand. In any event decisions have to be taken on new investments. Should existing equipment be replaced? Should more space be acquired?
If the answer to both these questions is yes, then decisions have to be made on which equipment or space should be chosen.
It is very rare that one piece of equipment is the only absolutely correct one for the job. Suppliers compete, and most products have significant differences. They may cost more but last longer, or cost less but be more expensive to run. Work space in offices and shops also comes in different shapes, sizes and locations. All these capital decisions have two things in common. They usually
involve (a) spending or committing a lump sum now to get (b) a stream of benefits in the future.
Anyone buying a new piece of equipment expects it to be used to help make more products that will in turn produce cash and profits. The same argument is true if equipment is being replaced. The equipment that produces the best return should be chosen. But how will it be chosen? What tools are available to help make a sound financial choice?
Clearly it is important to try to get these decisions right. After all, these types of assets tend to be around for a long time. Also, their resale value declines rapidly in the early years. Anyone who has bought a new car will not need further emphasis on this point.
Average return on capital employed (ARCE)
We know that one of the two primary objectives of a business is to make a satisfactory return on the capital employed in the business. Clearly, any new capital investment will have to achieve that same objective. Until now we have only looked at the return on capital employed for an individual year. This would not be enough to see if a new investment proposal was worthwhile. Imagine your own reaction if someone asked you for £1,000 and explained how they could return only £200 at the end of the first year. You would expect them to come up with a complete proposal, one that covered the return of all the money you had lent - plus interest. The same is true of any capital investment proposal. We have 'lent' the project, whatever it may be, a sum of capital. We expect a return on that capital over the working life of the assets bought. The ARCE method sets out to do just that. It measures the average profit over the life of a project and compares that with the capital employed.
Let us take an example to illustrate the method. A company is considering buying a new lathe for £5,000. The working life of the lathe will be five years, by which time it will be worthless. Net profit from the output of the lathe will come in as shown in Table 10.1.
Over the five years the capital invested in the lathe will produce an average return of £1,135 (5,675 ÷ 5) each year. As the capital concerned is £5,000 and the average return is £1,135, then the average return on the capital employed is 22.7 per cent or (1,135 ÷ 5,000) - 100.
This figure is simple to calculate and is of some help. For example, if on average the business buying the lathe is making a return of 30 per cent on capital employed, then buying the lathe will dilute the ROCE of the business as a whole.
Table 10.2 shows what happens to ROCE when the present business and the new project are 'merged' together to form the new business.
While this information is of some use as a tool for helping with capital investment decisions generally, ARCE has two severe limitations. Let us suppose that the company has decided to buy a lathe - but there are two on offer. The first we have already examined. Profits from this lathe will build up gradually over the years and tail off sharply in the final year. The second lathe has rather different characteristics. It swings into action immediately, achieves high profits and tails off over the last three years (see Table 10.3).
As the overall total profits are the same, over the five years this investment will
also produce an ARCE of 22.7 per cent. And yet, if all other factors were equal
and only the figures on these pages had to be considered, most businesspeople
would prefer the second lathe project. The reason they would give is that they
get their profit in quicker. By the end of the second year that lathe would have
paid for itself, while the first would not 'break even' until well into year 4.
This would be a 'gut reaction' and it would probably be right. That does not
mean that gut reactions are better than financial techniques; it just means we
have got the wrong technique. We need a technique that takes account of when
the money comes in - clearly timing matters.
This leads into average rate of return's other major failing. It uses profit as
one of the measures, although a business may have to wait months or even
years for that profit to be realized as cash.
The other measure it uses is the cash spent on a capital investment, so like is
not being compared with like: profit on the top of the equation and cash on the
bottom. Two projects could generate identical profits, but if one generated
those profits in immediate cash, the ARCE technique would not recognize it.
But a businessperson's 'gut reaction' would once again choose the project that
brought in the cash the soonest. And once again it'd be right.
Payback period
A more popular technique for evaluating capital investment decisions is the payback period method. Payback attempts to overcome the fundamental weaknesses of the ARCE method. It compares the cash cost of the initial investment with the annual cash net inflows (or savings) that are generated by the investment. This goes beyond simply calculating profit as shown in the profit-and-loss account, which is governed by the realization concept. The timing of the cash movements is calculated. That is, for example, when debtors will actually pay up, and when suppliers will have to be paid. By using cash in both elements it is comparing like with like. Payback also attempts to deal with the timing issue by measuring the time taken for the initial cost to be recovered. Table 10.4 illustrates the method. The payment period is three years. That is when the £10,000 initial cash cost has been matched by the annual net cash inflows of £2,000, £4,000 and £4,000 of the first three years. Now we have a method that uses cash and takes some account of time.
Unfortunately it leaves us with a result that is difficult to compare directly with the profit performance of the rest of the business. If the business is currently making a 25 per cent return on capital employed, and a project has a payback period of three years, will the project enhance or reduce overall profitability? Without further calculation this question cannot be answered - and even then the answer will not necessarily be correct. Look again at the preceding example.
The payback method looks only at the period taken to repay the initial investment. The following years are completely ignored, and yet the net cash inflows in those years are a benefit to the business, and their size matters. This weakness is brought sharply into focus when competing projects are being compared.
Let us suppose your task is to choose between Projects A and B purely on financial criteria (see Table 10.5). The payback period for each proposal is three years, which signals that each project is equally acceptable on financial grounds. Clearly this is nonsense. It seems highly probable that Project B, which generates extra £6,000 cash, is a better bet. Payback has some merits, not least of which is its simplicity. It is often used as a cut-off criterion in the first stages of an evaluation. In other words, a business decides that it will not look at any project with a payback period greater than, say, four years. This provides a common starting point from which a more exacting comparison can be made. Beyond that use, the method's weaknesses make it a poor tool to use in investment decisions in a small business. Big businesses do not expect to get all their capital investment decisions right. Small businesses have to, as their very survival depends on it.
Discounted cash flow
Neither the ARCE nor the payback method for evaluating capital investment projects is wholly satisfactory. They provide neither a sound technique for deciding whether or not to invest, nor a technique to help choose between competing projects. They fail for the reasons already described, but they also fail for a more fundamental reason. The businessperson's gut feeling that timing is important is perhaps more true than he or she thinks. No one is going to invest a pound today, unless he or she expects to get back more than a pound at some future date. The level of that reward, if you like, is related in some way to the riskiness of the investment. But whatever the level of risk, no one wants less money back as that would involve making a loss. The factor that alters the value of an investment over time is the interest rate. The longer the time period or the higher the interest rate, the larger is the final sum returned. This relationship between the initial sum invested and the sum finally returned is familiarly known as compound interest. The compound interest equation that calculates the precise figure for any interest rate or time period is:
In this equation P = the initial sum invested, or principle, r = the interest rate expressed in decimals, and n = the time period in years. So if we invest £100 for three years at 10 per cent we can expect a future value of:
£100 - (1 + 0.1) 3
= £100 - (1.1) 3
= £100 - (1.1 - 1.1 - 1.1)
= £100 - 1.331
= £133.10
For the doubters, the sum can be worked out in longhand (Table 10.6).
You could consider the situation to be similar to looking through a telescope: looking forward in time through the compound interest equation magnifies the value of an investment. But what happens when you look through the other end of a telescope? Images appear to shrink. To some extent this is similar to the problem a businessman might face when making up his mind about capital investment decisions. He knows he is not prepared to pay £1 now to get £1 back in the future; that would be bad business. What he has to calculate is exactly how much less than £1 he would pay to receive £1 back in, say, one year's time. The thinking might go something like this. 'For this kind of investment I have to make 10 per cent profit, so I need to know what figure less 10 per cent will equal £1, and that is what I will pay now.' This is rather like moving to the other end of the telescope and looking backwards. This problem is exactly the inverse of compounding and is called discounting. To calculate the appropriate discount factor we simply stand the compound interest equation on its head.
Some general factors in investment decisions
Some considerable space has been devoted to the subject of new investment appraisal. It is an area where many small businesses get into fatal problems very early on. People starting up rarely have a proper framework for deciding how much money to invest in a business idea. They are usually more concerned with how to raise the money. A critical look using discounted cash flow would probably change their minds, both about how much to spend on starting up and on expansion. However, in the end, any investment appraisal is only as good as the information
that is used to build up the cash-flow forecast. Much of the benefit in using DCF is that it forces investors to think through the whole decision thoroughly. The bulk of the work in investment appraisal is concerned with:
1. Assessing market size, market share, market growth and selling price.
2. Estimating and phasing the initial cost of the investment; working life of facilities; working capital requirements.
3. Assessing of plant output rate.
4. Ensuring that the provision of additional services and ancillaries has not been overlooked.
5. Estimating operating costs.
6. Estimating the rate of taxation.
7. Estimating the residual value of the asset
