Knowing when to buy equipment and make an investment is hard.

Most don’t even know how to determine if they did the right analysis.

Today we break down how to analyze growth-related capital expenditures.

1. Identify your options
2. Calculate the cost
3. Analyze scenarios & assess your risks
4. Valuing reinvestment versus cashing out

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The 5-step process to analyze growth CapEx

Maintenance CapEx ended up taking more space than I expected, so we’ll discuss growth CapEx and distributions more in-depth next week.

As a primer on Growth CapEx:

1. Identify and prioritize growth potential
2. Evaluate the possibilities against your goals
3. Calculate the cost (Payback, ROI, and my saucy opinions on IRR & NPV)
4. Assess your risks and do scenario planning
5. Make a choice

Calculating Growth CapEx

We definite growth capex as any capital expenditure that is in addition to maintenance capex. Maintenance capex cost is the equipment needed to continue operations at the currently level.

Upgrading for greater production? Growth CapEx.

Buying equipment for a new product line? Growth CapEx.

Now, it’s not always this simple. Sometimes you’ll be replacing an old machine with the next upgrade because it was “time.” That’s maintenance. But if you upgrade to increase capacity, when a lower capacity option was available, it would be partially maintenance and partially growth.

How you identify the different part is up to you and your discretion in your business.

The key is to consistently apply the same rules, as they rules help you manage your costs.

I’ve seen it too often: department leader loves to play with toys. He convinces the CEO, COO, etc that they need to replace the old equipment and only brings options that are significant upgrades.

When asked, it’s then revealed that simple maintenance or equal replacement is available for a significantly lower cost.

If you want to learn more about maintenance capex,  check out last week’s newsletter .

This week we focus on growth capex and a process for identifying the pluses and minuses of the spend.

1. Identify and prioritize growth potential
2. Evaluate the possibilities against your goals
3. Calculate the cost (Payback, ROI, and my saucy opinions on IRR & NPV)
4. Assess your risks and do scenario planning
5. Make a choice

Identifying and prioritizing growth potential

I’ve heard it too often: “I just evaluate the opportunities that are brought to me.”

Noooooo.

Did you hear that? NOOOOOOOO.

There are a few problems with this. Each decision is not independent of the other.

When you evaluate based on who brings the request, you prioritize those who are the loudest. Then, the next time there is a need or want, guess what you get? Everyone screaming at you.

Not only this, but there is only so much money to go around. Choosing one growth initiative could mean you couldn’t afford the next one.

Creating a procedure for accepting and reviewing these initiatives assures you make the best decision you can with the best available information.

Create a list of possibilities.

This is the part where you invite others into the process. What their dreams or desires? What would make their jobs better? What opportunities are there in the market?

There are no limitations to this. Look at:

1. New facilities
2. New equipment
3. New technology
4. Different markets
5. Different business lines
6. New businesses all together
7. and anything else you can think of

Let people brainstorm in large groups, work in small groups, or work individually.

When people bring proposals, they should identify the purpose, timing, and cost of their suggestions. This helps leadership have complete(ish) information to assess them as a group.

Evaluate the possibilities against your strategic goals.

If you aren’t doing annual strategic planning, this is your call to start. Each business should set aside time each year to:

1. Review the prior year
2. Set 3-5 year goals
3. Prepare for the next year

By doing this, you make sure you move from reactive mode to proactive mode.

When you have a plan, you assess new opportunities against that plan.

When looking at new growth capex opportunities, you need to assess them again the strategic plan.

You need to ask:

1. Which most aligns with my goals?
2. Which pair together well?
3. What could I afford?

By evaluating them TOGETHER, we assure we don’t get bias that can occur when viewing them alone.

Calculate the cost

Payback period:

 

The shorter the payback period, the less risky the investment is considered to be. This is common sense, but let’s use an example. Say you have a service that requires employees to use a vehicle to go onsite. Say you have an hourly rate of $200/hr.

Employee cost: $65/hr

Maintenance cost (fuel): $12/hr

Difference: $123/hr

If you make $123/hr and the vehicle cost $50,000, it’d take 406 hours of vehicle time to pay back the vehicle.

Depending on how many hours per day the vehicle is in use, the payback time could be as little as a few months.

Net Present Value (NPV):

 

NPV takes cash inflows and outflows over a period of time and makes adjustments based on rerun or discount rate. A positive number means the investment is profitable, but it’s rarely that easy.

This is essentially giving you the total amount of money made, in a dollar value.

The discount rate should be your cost of capital (either via loan or LOC) or your required rate of return.

This calculation can be useful when comparing multiple options side-by-side.

Overall, I steer away from this and find that it’s often a flaw to rely on it.

1. Both discount rates and cash flows are assumptions or estimates.
2. Complicated to calculate, which means most don’t understand it.
3. Easy to manipulate estimates, making it not reliable.
4. Doesn’t account for project size.

Internal Rate of Return (IRR):

 

This returns a value in a percentage and can give individual years and total return.

It’s the same formula as NPV, but you set the NPV to zero and solve for the discount rate.

Similar to NPV, I like to use this as a comparison between options, instead of an independent number.

When IRR is greater than the cost of capital, it’s considered to be a good choice, though it’s not that simple. Again, a number of estimates are made, so there is still risk associated with making the decision to move forward.

Many large companies will often have a required rate of return for any project.

 

Return on Investment (ROI):

 

Like I mentioned, I’m not a huge fan of NPV and IRR because of their complexity.

To me, that’s where ROI excels. It’s easy to calculate and is easily comparable to other ROI calculations on other assets.

If cash flows are fairly regular, you can even divide this by the number of years of the investment and get an average rate of return.

While IRR and NPV are better for uneven returns, as they capture time value of money, I’ve found very few applications that the confusion is worth.

Impact on cash flows

I like more practical calculations, in case you couldn’t tell by now… with the others being hard to translate to a non-finance party, this is one of my favorite things.

It’s also one of the most important.

Buying that piece of equipment costs you money. Either in cash now or future cash flow.

If buying the equipment in cash, ask: How long will it take to replenish the cash amount?

If buying the equipment with a loan, ask: What is the impact on cash flow? If positive, how long will it take you to replenish? If negative, how many business variables would have to change to make it catastrophic?

While the cash flow impact may not be significant enough to change the business, the question also becomes is it going to impact future decisions?

Too much of a debt load could make future needs hard to acquire.

Using all your cash could limit your future options to loans only.

Consider all the secondary and tertiary impacts when considering this.

Analyze scenarios & assess your risks

Scenario Analysis:

At the beginning of today’s article, I mentioned the dangers of analyzing opportunities as they come.

By doing annual and strategic planning, you’re able to do scenario analysis and compare the options side-by-side.

I know I gave you a number of calculations above. Don’t do all of them. Stick to what works best for you. If you don’t know what to start with, choose payback period and ROI.

Now, for each option, run the numbers and determine the values of the calculations you chose.

You can now compare them side-by-side.

A few things of note:

1. Include a good and bad option for each scenario to account for risk.
2. Make sure you use the same or similar (with an explanation) assumptions on each scenario.
3. Ask people to check your math. Even the best make mistakes… so best not to make decisions on bad numbers.
4. Include scenarios that take into account multiple buys. This isn’t just Machine 1 vs Machine 2. It’s well, we could afford 2 & 3. Compare that scenario to 1, 5, & 6.
5. Write up pros and cons of each scenario to provide additional color to the straight numbers. If comfortable, create a scoring system with other factors you favor, in addition to the math.

Risk Factors:

I’ve talked about risk a number of times in this newsletter, but even then, probably not enough.

One of the biggest risks companies face is miss-assessing their risk.

The problem, we are almost always miss-assessing it. It’s in the variability of our miss-assessment that we win.

I mentioned the pros and cons list above, which is a great place to establish your risk factors.

Ask about the risks:

1. Market
2. Financial
3. Operational

Spend the majority of your time on this step. It’s the most important because a miss-assessment could damage your business.

Once you’ve rated those risks, revisit step 1, where we established a worst and best-case scenario and ask if they’re still accurate.

Then, you have to determine your own personal risk tolerance.

No one can answer this for you. Only you.

Make a choice

Once you’ve done the calculations, assessed the risk, and ran your scenarios, you’re ready to make a decision.

Well, let me take that back. You have all you need to make a decision…

The decision now gets put through the lens of Owner’s desires. Or, owner distribution/dividends.

Determine your desire.

This is the beauty and difficulty of owning a business. How you allocate excess capital is up to you.

You could choose to defer maintenance because you want a lake house.

You could choose the sports car over a new, expensive initiative.

Neither is wrong (though I might argue creating hardship through deferred maintenance for loyal employees because you want a toy is wrong), but a personal choice.

Once you’ve determined maintenance CapEx, as the owner, you get to determine:

1. How much do I allocate to growth CapEx?
2. How much do I take out of the business?
3. How much do I leave for tomorrow?

We do this calculation on Operating Cash Flow, because doing it on Profit can strangle the business of money. OCF represents money in the door, thus a better number to use for distributions.

I encourage owners to split this excess into 2 categories:

1. Distribute
2. Set-aside

Distribute a set percentage each time you have an excess after Maintenance CapEx, or what I’ve termed Maintenance Cash Flow.

 

This assures that the business doesn’t own you, but that you own the business. This gives you a little more than your salary, so you’re actually rewarded for owning a business. This could b

 

e 25%, 5%, 75%, or 50%. It’s your money… pick your number.

The set-aside is for future potential growth opportunities. This is the money that you’re truly asking, “what is the best return I can get?”

If you’re a sole owner, you should evaluate your opportunities independent of your company.

You should be comparing:

1. Reinvestment
2. Stock market
3. Real estate
4. Private investment funds
5. Other business opportunities

By doing the analysis in your business we suggested above, you’ll have the information you need to make the best decision for yourself personally.

Create a plan.

You want to plan the year out, based on cash flow and need, to assure you don’t buy things too early or too late.

But also: be flexible. Conditions change. You made the plan based on a set of assumptions.

If the conditions change, reassess your needs.

Communicate it.

I can’t tell you how to make decisions.

Every business and every owner is different.

The only thing I can tell you is to be consistent with the culture of your organization.

If you share details with your leadership team, let them know why certain choices were made with both maintenance and growth CapEx.

If you don’t, don’t share.

If you share with your whole staff, keep sharing.

These choices can directly impact someone’s job, so be sure you communicate it in a way to not degrade or discourage those who didn’t get their request.

 

CONTENT CORNER

1. I keep telling myself I’ll ignore AI, but it keeps drawing me back in. Tuesday Microsoft announced they were  building AI into their operating system . Co-Pilot will help you access Windows in a way you never have before. I think it’s safe to say it’ll transform our experience on computers. While I think it’ll be a bit before it integrates really well with allll the apps, it will slowly change the way we work. Probably the biggest AI announcement to date.
2. I mentioned last week that  I'm running a cohort  with some friends. If you're interested in building a business off the back of social media, this cohort is for you. For this week only you can use the code LAUNCH30 to get 30% off.  Join us !

 

Thank you for reading!

If you have questions, feedback, or want to work with me, reply to this email. I reply to all emails and would love to get to know all of you.

See you next week,

-Kurtis