Venture Momentum Article - Capital Budgeting & Efficiency

3 Indicators to Help You Widely Invest Your Scarce Capital
by Anthony Nassar

Do you systematically run some numbers before investing in a piece of equipment, the development of a new product, or the launch of a new marketing campaign?

If you don’t, you’re not alone. But if you don’t, how can you tell whether the money you are investing is ultimately adding value to your venture? After all, isn’t increasing the value of your start-up one of your primary objectives, second of course to having tremendous fun doing it?

In today’s article, we’ll look at a case study involving a fictitious capital efficient start-up (“CapEf”) that produces constantly changing color collateral. The output is currently generated by an outside printing service for a non-trivial cost. CapEf’s CEO, Julie, is contemplating the idea of bringing the process in-house by acquiring a quality color laser printer in an effort to achieve substantial cost savings for this activity. She is going to prepare a feasibility analysis resulting in 3 feasibility indicators that will help her make a decision. Julie expects the useful life of the printer to be 5 years, and will therefore choose this same period as a time horizon for her analysis.

Below we will discuss Julie’s summary findings. The detailed metrics for this analysis are available online.

CapEf prints 125 pages once a month on high gloss 8.5”x11” stock, and expects the volume to grow 20% per year. The average marginal cost of the printing service is $1.80/page.

The cost of acquiring the printer - including sales tax, 3-year onsite protection, network installation, and training - is $3,500. Card stock cost is 60c/page. In addition, the black toner costs $160 and each of the 3 color toners costs $220 for a yield of 5,000 pages. This results in an average marginal cost per page produced in-house of 76c.

Julie can now develop a 5 year cash flow projection for each of the 2 scenarios – printing service and in-house processing – and compare the two cash flows as shown below. She will ignore the effects of income taxes on her cash flow analysis:

The above net cash flow figures are quite revealing. At first glance, the acquisition of the color printer could very well be a good move, since the negative cash flow experienced in Year 1 - principally due to the acquisition of the printer - is largely offset by the positive cash flow in Year 2. And healthy positive cash flows in years 3, 4 and 5 come to supplement the encouraging results from year 2.

But how does this investment fare relative to CapEf’s investment strategy and required rate of return?

This is what Julie is going to find out by computing the following 3 feasibility indicators. She will be able to make a decision only after she has compared these 3 feasibility indicators with CapEf’s investment guidelines as set by its Board of Directors:

Payback Period (PB): This is the period needed to recover the initial capital investment. In this case it will take 1.66 years to recover the total acquisition cost of the printer. Julie will consider this information carefully in her decision, as it tells her how long the invested funds will be tied up in this project. However, she will keep in mind that this method ignores all cash flows beyond the PB, as well as the time value of money. We will revisit the suitability of this PB value later in this article.

Net Present Value (NPV): This is the sum of the cash flows in Years 1 through 5 after they've been discounted back to the present using CapEf’s cost of capital as discount rate. CapEf has a total of $10,000 in common stock and $490,000 in preferred stock - both requiring a 40% return - and a debt of $100,000 costing an effective after tax rate of 10%. This results in an average cost of capital of 37%, and an NPV of $2,352. A positive NPV is a desirable outcome as it indicates the existence of a “cash flow surplus” over and above that provided by the minimum required rate of return of 37%, which is implied by the cost of capital.

Internal Rate of Return (IRR): This is the discount rate that would constrain the Net Present Value to equal 0. In the case of CapEf, the IRR is 148%, which is significantly higher than its average cost of capital. In other words, the savings realized from processing the printing in-house generate a return that is more than 7X that of the company’s required rate of return.

The last step in Julie’s analysis is a comparison between the values of the 3 feasibility indicators and the investment guidelines set by CapEf’s Board of Directors. In order to factor the risks associated with the various projects undertaken by CapEf, its Board has set somewhat tough investment guidelines:

PB must be less than or equal to 2 years.

NPV must be greater than the initial investment times 30% - $1,050 in this case.

IRR must be 50% higher than the average cost of capital – 56% in this case.

Julie concludes that the project fulfills all the above conditions and is a go! Using conditional formatting in her spreadsheet, she summarizes her findings as follows, (in green are all the results that passed the investment guidelines):

However, before giving the green light for this project, Julie finds out from her Director of Marketing that the monthly volume was erroneously reported as 125 pages instead of 80 pages. She reruns the analysis and finds new values for the feasibility indicators:

Based on the Board’s investment guidelines, Julie must reject the project because it fails the PB and NPV tests which are displayed in red cells.

Using a couple of what-if-scenarios, she determines that a monthly volume of 100 pages would be sufficient to make the project viable, as depicted in the table below. She expects to reach such a volume in 3 months and may obtain approval from the Board to override the guidelines, considering that the indicators are at a very close distance from the allowed threshold of 2 years PB, $1,050 NPV and 56% IRR.

I hope that this case study sheds some light on the insights you can acquire prior to making an investment decision simply by performing a feasibility study, and deriving certain meaningful indicators. Please note that this case study was simplified for the sake of this article. More complex considerations come into play if you are taking into account the effects of taxes on the investment, contemplating mutually exclusive projects, or if the search for the IRR yields multiple values.

This article was first published in the June 2004 issue of our e-zine, Propel Your Venture.

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