The Cumulative Impact of Past Capex Decisions on Business Value

Why it is critical to measure, track, and evaluate the impact of your major capital expenditure decisions.

It has been often said that you can’t manage what you don’t measure. Far too often, small to medium sized business managers fail to objectively measure the long term impact of their major capital expenditures. 

​Normally, a ton of work is done up front, by choosing the right equipment, design, vendors etc., with a clear focus on the future benefits for the company.  However, often too little work is done on return expectations under best case/worst case scenarios, let alone ensuring on-going evaluation and assessment once the project is completed. 
 
The cumulative impact of your capex decisions can have a major effect on your long term profitability and perhaps even more importantly, the value of your business.  It goes without saying, that if you make a series of good capital project decisions that result in shorter than expected paybacks or higher ROI’s, it can have a very positive effect on the business value and profits. Conversely, by making a series of marginal or poor capex decisions, it can really devalue a business over the long term.

For many established businesses, a quick way to evaluate the cumulative impact of your capital expenditure decisions is to look at your historical depreciation plus capital lease expense in relation to your operating profit.  If the former has been growing faster than the later, then you are likely not setting the bar high enough on your decisions to spend capital, unless you are consciously and aggressively growing market share or investing in new business areas that are expected to have a long term positive impact.  Of course, there are ways to accelerate depreciation, based on allowable tax rates for example, that can really skew this metric and it is therefore most applicable when you use depreciation rates that match the useful life of the purchased asset.

One of the areas that managers need to consider, when making capex decisions, is their weighted average cost of capital (WACC – ask your accountant to calculate/estimate your WACC - every private business owner needs to know this number).  In order to build long-term enterprise value, the return on capital expenditures should always be higher than your WACC, even under your worst-case scenarios.  This is especially critical for expansionary projects.  It needs to be the minimum hurdle rate you use to assess the viability of every new project.

Companies with little or no debt can destroy business value by investing in projects that provide returns that are insufficient to cover their cost of capital, even if they actually contribute to the business earnings.  Obviously for companies with high levels of debt, the project could have severe repercussions should it not generate the expected cash flow.  Even so, the prudent use of debt financing can often lower your WACC, especially for established companies with a solid asset base and a positive cash flow track record. Therefore, debt financing should be considered, as it can widen the spread between the project’s return and your WACC, which builds enterprise value.

Finally, don’t forget to assess the impact of the project will have on working capital.  Like your fixed capital, there is a cost associated with working capital, regardless of its source, and therefore you need to get a return over and above its cost.  Capital projects that increase efficiency can decrease working capital as well as lower other operating costs. However, projects that are undertaken to facilitate topline growth can result in increases in inventory or receivables for example.  All positive and negative impacts to working capital need to part of the evaluation process.

Knowing your business’s track record on each major project helps your fine tune your evaluation process, and thereby provide the basis for continuous improvement.  An accurate, objective and analytical assessment of the project’s ROI needs to be imbedded into your capital decision making process, if the goal is to build real and sustained value into your business.

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