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Friday, April 18, 2014

Capital Equipment: Calculating Your Money’s Worth

Marilyn GettingerSupply professionals who understand the opportunities and challenges in purchasing new and used equipment, as well as the leasing option, are able to help their organizations make decisions that best suit objectives and bottom-line goals.

The supply chain professional also can offer important information when the organization is setting up its yearly capital expenditure budget. Often company departmental personnel find it disappointing and perplexing when their proposals for capital purchases are not accepted. Supply professionals, as well, often do not understand why their research, sourcing, and negotiations meet with failed capital proposals.

Many organizations have a standard process for capital budgeting, including a yearly review of all proposals and an analysis and comparison by a capital appropriation committee. The proposals that are most important to the company’s objectives, goals, profitability, and return on investment criteria are presented to senior management and the board of directors for approval. Even though a proposal might be worthwhile, it might not reach that list because other equipment and machinery requirements are more worthy for funding.

Capital budgeting is a critical expertise. Many organizations have made poor decisions and consequently found themselves in or near bankruptcy.

The supply professional who is part of the team for identifying capital equipment purchases should not only understand the various factors of purchasing and/or leasing major equipment but also the various methods used to determine which capital projects offer the best value to the organization.

In preparing information for the selection of capital projects, a committee may use three common techniques: (1) annual rate of return, (2) cash payback, and (3) discounted cash flow, which includes the net present value method and the internal rate of return method. The supply professional who does a lot of the sourcing groundwork for a capital appropriation submission should understand how the organization will analyze it and make the capital purchase decisions.

Credit: Keerati at FreeDigitalPhotos.net

Credit: Keerati at FreeDigitalPhotos.net

The supply professional should identify the organization’s minimum rate of return or its cost of capital. Cost of capital is the rate of return that the company expects to pay on all borrowed money.

 

1) Annual Rate of Return

The method is based on accounting data, and it indicates the profitability of a capital expenditure.

The Formula for Annual Rate of Return is:

Expected Annual Net Income + Average Investment = Annual Rate of Return

 

Average Investment =

Original Investment + Salvage or residual value at the end of equipment’s useful life ÷ 2

$13,000 = Expected Annual Net Income from projected income statement

Original Equipment Investment = $130,000

Residual: $0

$130,000 + $0 ÷ 2 = $65,000

 

$13,000 ÷ $65,000 = 20% annual rate of return

 

The next step is to compare this annual rate of return to the organization’s minimum rate of return. If it is less, then this particular capital purchase will not be presented for final review and approval.

 

2) Cash Payback 

This method is very useful as an initial screening tool. It is also an important factor for an organization that desires a fast turnaround on its investment due to a weak cash position.

The Formula for the Cash Payback is:

Cost of Capital Investment ÷ Annual Cash Inflow = Cash Payback Period

 

Annual Cash Inflow = Net Income + Depreciation Expense

Net Income                                         = $13,000

+ Depreciation Expense                  = $13,000

Annual Cash Inflow                          = $26,000

Cost of Capital Investment             = $130,000

 

$130,000 ÷ $26,000                        = 5 years payback period

 

A shorter payback period offers a quick recovery of the investment and frees up cash for other projects. It also minimizes the risks of obsolescence and economic conditions.

 

3) Discounted Cash Flow

This is considered an important technique because it considers both the estimated total cash flows from the investment and the time value of money.

The discounted cash flow includes two methods: Net Present Value and Internal Rate of Return

The net present value method brings cash flows from future years to their present value and then compares it to the capital outlay for the investment. If the net present value is zero or positive, the proposal is acceptable.

The net present value is found by using a net present table and the organization’s desired rate of return.

For example:

Cash Flow                          = $26,000

10 periods

Rate of Return                   = 15%

Net Present Value Factor (from net present table) = 5.01877, based on 10 periods and rate of return of 15%

$26,000 x 5.01877 = $130,488 in today’s terms

Present Value of Future Cash Inflows         = $130,488

Capital Investment                                           = $130,000

Net Present Value                                            = $        488 (Positive)

 

The internal rate of return method finds the interest yield of the potential investment, and it is the rate that will cause the present value of the proposed capital expenditure to equal the present value of the expected annual cash inflows.

The Formula for the Internal Rate of Return is:

1. Capital Investment ÷ Annual Cash Inflows = Internal Rate of Return Factor

$130,000 ÷ $26,000 = 5.0 internal rate of return factor

2. The internal rate of return factor and the present value of an annuity of 1 table = IRR

Example of an annuity table of 1 with 10 periods:

 

10 Periods = 5% 6% 8% 9% 10% 11% 12% 15%
7.72173 7.36009 6.71008 6.41766 6.14457 5.88923 5.65022 5.01877

 

Since the internal rate of return factor is closest to 5.01877, which is 15%, the next step is to compare the internal rate of return (IRR) of 15% with the organization’s desired rate of return. If the IRR is greater than the desired rate, then the capital purchase proposal is acceptable.

 

Marilyn Gettinger is owner and principal of New Directions Consulting Group, which works with organizations on improving their supply chains through process streamlining and reengineering. New Directions Consulting Group offers workshops and consulting to companies from 30 employees to multinational corporations to upgrade purchasing, inventory, and supply chain processes. Gettinger, who earned her MBA from Fairleigh Dickinson University, teaches total quality management, supply chain management, and international trade at several post-secondary schools. She holds a C.P.M. and is a member of the Institute for Supply Management and the American Production and Inventory Control Society.

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