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Making the Case for Capital Expenditures

Fri, 01/14/2005 - 8:13am
New equipment will help you meet production requirements, but getting it means justifying a capital expense. Here's how to make that process a success.
By Lloyd Morgan, Contributor
In most modern organizations, everyone competes for the same pile of capital allocated for project work. The difficult aspect of this process for many engineers, however, is learning to make a case for a project from a non-engineering perspective. While engineers will understand the technical reasons why an expense is needed, they're often in the dark about related financial issues - and these are the details that those holding the purse strings need to know. This article identifies ways to make any large-scale project more internally competitive by explaining how to deliver a capital-improvement request in terms any accounting department will understand.
ROI and other terms to know
When most approvers look at an equipment purchase or investment option, they'll first do a Simple Return On Investment or ROI calculation. To calculate ROI, the total cost is divided by the saving in order to determine a rough payback period for the expenditure. Any payback within a two- to three-year period is typically worthy of further investigation. As long as the ratio of capital versus expense is not too extreme, this is a good rule to follow.

The next major issue to understand is the Time Value of Money. The underlying principle here is that a dollar today is worth more than a dollar in the future. Therefore, if you feel you have a viable project, the first thing to do is identify the real cash flow over the life of the project or analysis period. By doing this, you can begin to calculate the key metrics that most finance groups will use to evaluate your capital request. These metrics are typically compared across all investment opportunities within the organization, so that the decision makers can make the best overall decisions for the company.

The two most important metrics used today are Net Present Value (NPV) and Internal Rate of Return (IRR). NPV is the present value of the project's cash inflows minus the present value of the project's cash outflows. It indicates the expected impact of the project on the value of the firm. A positive NPV increases the value of the firm. When comparing among mutually exclusive projects, the highest NPV wins!

The IRR is that discount or interest rate which will cause the present value of all future cash flows to equal the incremental investment. In other words, it's the discount rate at which the NPV of a project eventually equals zero. All projects with an IRR greater than the cost of capital should be accepted. When comparing projects, the highest IRR wins (as long as it's greater than the cost of capital!). But it is important to identify the company's true cost of capital when performing these calculations. A more accurate reflection of the discount rate to be used is the Weighted Average Cost of Capital (WACC). This is a calculation of a company's cost of capital that weights each source of capital appropriately. Capital sources include common stock, preferred stock, bonds, and any other long term debt.
Using the metrics
When and how are these metrics used for a project? NPV is typically better when comparing mutually exclusive project alternatives. It implicitly assumes that the project's cash flows can be reinvested at the firm's cost of capital. This is probably a more realistic assumption. The IRR metric implicitly assumes that the cash flows can be reinvested at the project's IRR. Since each project in the company is likely to have a different IRR, this assumption may not be as sound. In the U.S., an acceptable hurdle rate is typically the cost of money plus 15% to 20%. So as a reference point, an IRR over 30% is good.

My experience with major corporations has shown that there are many other factors that can affect the decision process. Things such as current economic conditions, the time of year (tend to be more conservative in the beginning and more aggressive toward the end), the amount of internal competition for money, and the type of project all influence the decision. For example, a project that is strategically important to the future success of the organization may be allowed a much lower hurdle rate than a tactical one that focuses on immediate savings opportunities. Therefore, you need to make both the NPV and IRR as attractive as possible to improve your project's chances of approval.

Some of the inputs you will need to calculate these metrics for your project or to give to your financial representative include:

•Initial investment
•Cash flow over time
•Cost of capital (probably get from internal finance person)
•Investment tax credits
•Operating expenses
•Depreciation

It is important to understand that some of these parameters may be company specific or government regulated. As an example, the analysis period, planning horizon, or life span of equipment (depreciation period) may be pre-established by internal corporate policies or regulated by the federal government. The discount rate (or cost of capital) will vary depending on whether the project is financed via debt, equity, or a mix of both. Hence, the WACC calculation mentioned previously. And lastly, investment tax credits may be available at the national, state, regional, and/or local level.

Some other key components to preparing your project justification package will be to identify:

•*Initial cost versus operating expense
•*Cash versus non-cash analysis (write-offs, depreciation, residual values, etc.)
•*One-time costs (severance, etc.)
•*Transition costs
•*Salvage values of equipment
Capital sharpshooting
Once you've completed the financial justification for your project, you still might need help to make it more competitive. What can you do? Begin what I call "Capital Sharpshooting." The following "sharpshooting" techniques were created to improve the financial justification of your project without losing the value of its benefits. They are:

•*Value-Engineering Method
•*Capital "Challenge" Process
•*Focused Technology vs. System-Wide Analysis

Value-Engineering Methodology was born out of the construction industry, where certain components of a project can be viewed as independent pieces. This might apply to your project: Various components of the project may be able to be eliminated without compromising the end result. Lower cost components (substitutions) may be used for non-essential portions of the project. This is typically the first line of attack by the financial community, so be prepared to defend it! It is a good exercise to perform early on so that the project manager can quickly identify what is a "must have" versus a "nice to have" for the project. It is important that this up-front honesty is communicated to the rest of the project team.

Keep in mind, that this approach has the potential to cut the lowest performing portions of a project and keep only the highest performing portions based solely on ROI. It's important not to let "cherry picking" compromise the original design or its ability to expand over time. This is especially true with a tightly integrated solution where the components have strong interdependencies.

The Capital "Challenge" Process is currently popular within my existing client base. This approach is typically used for more costly, complex projects or projects that touch on many areas of an organization. It requires that a cross-functional team be established that challenges the Base Case proposal being brought forward by the project manager. This process can be completed relatively quickly (anywhere from a few days to a few weeks). The objectives are:

•*To establish a cross-functional team that brainstorms system components
•*Assign sub-teams to follow-up on evaluating alternatives
•*Establish risk and priority factors
•*Perform a cost/benefit analysis on the alternatives
•*Review financial options
•*Assign weighted ranking to recommendations by cross-functional team

Sometimes an independent facilitator is used to guide the process and maintain objectivity. There are many firms that offer these services, and the format of the process varies, but usually has most of the following steps:

1. Establish the Cross-Functional Team: When pulling together the internal resources as part of this team, make sure they have the time and are committed to a quick turnaround of information. Be sure to include members from all affected areas, as well as a finance person.

2. Review the Base Case Proposal: The project manager responsible for the proposal will need to present his or her case to the team, explaining all components.

3. Break Project into Functional Areas: Usually the project manager takes the first shot at splitting the project into its functional areas. Other team members will comment and help bring different perspectives to the project.

4. Brainstorm/Challenge Session: During this session, the team challenges the design assumptions (growth rates, etc.), equipment selection, systems selection, and performance specifications. Aspects for review include over-design, excess performance requirements and unrealistic growth assumptions. The team prioritizes and uses a weighted ranking system to pursue cost-reduction opportunities.

5. Follow-up Work Assignments: Team members break to research process simplification, re-layout and design, and equipment substitution opportunities.

6. Evaluation Session: The team rejoins to review alternate designs, cost/benefit worksheets and financial options. The process ends by prioritizing the opportunities by fiscal attractiveness and project risk.

A third approach is a Focused Technology vs. System-Wide Analysis. This process is very effective for tightly integrated systems. Like the previous approaches, its objective is to break out and analyze the various components of a system. Some of the techniques used are time-phasing to achieve the end goal, volume phasing (5-year plan), modularity in design, and a strong focus on current project inhibitors.

By focusing on the components of a system, there may exist an opportunity to purchase portions of the solution each year and, over time, meet the end goal and capability that is required. Likewise, a look at the actual throughput demand for the system over time (or volume phasing) may show that the real performance needs are not required until later in the project. Sometimes you'll discover that there is a more modular approach to meeting the project's needs that may be more flexible for the business. More smaller pieces may be better than one big piece.

Another benefit of this approach is that it forces you to understand the current demand patterns and issues that are possible project inhibitors. For example, maybe we're designing a system to accommodate inventory levels that are too high. If inventory is reduced, an entirely different solution is possible. In other words, the design requirements may be based on poor practices that are driving a cost-prohibitive solution.

Another example could be demand variability. Maybe we're trying to accommodate a demand stream that is extremely variable due to poor scheduling practices. After smoothing out this demand, an entirely different solution could be possible. Granted, process improvements technologies/techniques must be in place before the project can plan on any change to current requirements.

Regardless of the approach taken to improve overall project justification, alternative financial options that can be researched include:

•*Leasing (moving capital to expense)
•*Purchasing used equipment (internally or externally)
•*Contracting the higher cost/lower value-added operations (3rd Party •*Logistics providers, packaging, labeling, etc.)
•*Internet bidding

Other "soft" benefits to be researched include sales & marketing opportunities, ergonomic, safety, and security improvements, as well as potential reductions in insurance premiums (IRI/FM, workman's compensation, etc.).

Good luck with your project!

Lloyd Morgan is a Partner at St. Onge Co., a York, PA-based engineering firm with experience in the design and project management of lean manufacturing facilities and high-performance distribution centers around the world. With 19 years experience in the material handing industry, Morgan has led major project efforts in network analysis, facility design and process improvement for Kraft Foods, ConAgra, Heinz, Pepsi, P&G, Baxter, Johnson & Johnson, Sony, and many other clients worldwide.
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