Every time you purchase a fixed asset for your company, you attempt to evaluate which option provides the greatest return on your investment over its useful life. Forecasting “capital productivity” offers a variety of ways to evaluate these choices and make the best decision. Here are two relatively simple methods to help you.
The most common and oldest formula, this method is based on the cash flow from the investment in a new asset. The investment includes the purchase price plus the cost of operating and maintaining the asset over its useful life. You are attempting to predict the net annual cash flow, or the amount the asset contributes to net profit plus its depreciation. Remember that depreciation is the amount of the asset’s cost that is supposedly “used up” during each year of its predicted useful life. So, as accumulated depreciation becomes a larger number on your balance sheet, you must make arrangements to replace those assets that are reaching the end of their productive lives and will no longer contribute to your profit.
You can calculate net annual cash flow with this formula:
(Investment in new asset ÷ total fixed assets including the new asset × predicted annual net profit including the contribution from the new asset) + (investment in the new asset ÷ recovery period)
Let’s say you want to buy a piece of equipment, and the total investment—including its price and the cost to operate and maintain it—is $10,000. You will have total fixed assets of $100,000, including the asset you are buying. You expect that your annual profit with the new asset will be $12,000, including $2,000 contributed by the new asset, and the new asset will be depreciated over five years (the recovery period).
Now, go back and plug all of this into the first formula:
($10,000 ÷ $100,000 × $12,000) + ($10,000 ÷ 5) = $3,200
This formula actually calculates the proportion of your total assets represented by the new asset, and it computes that same proportion of your predicted total profit. Then it adds the annual depreciation for the new asset.
If you divide the $10,000 investment by the $3,200 of net annual cash flow, the payback period would actually be 3.125 years, well under the recovery period; the investment would be “paid back” in full before the asset was fully depreciated, so it would still be producing profit for you. The annual return on assets (ROA) would be $3,200 ÷ $10,000, or a very healthy 32 percent.
The cash payback method is simple to calculate and a reasonably good risk indicator. The longer your payback period compared to the life of the asset, the higher the risk of making the investment. In this case, if the payback period were more than five years, you wouldn’t want to buy the asset.
The method has a few drawbacks. It doesn’t measure the ultimate objective of business: profitability. It also makes no allowance for variations in cash flow over time and treats the value of dollars today as equivalent to future value (i.e., it ignores the time value of money when it is altered by inflation).
Since assets usually have some value after they are fully depreciated on the balance sheet, there is another method that considers this salvage (liquidation) value as a protection against some of the investment risk. Using the payback bailout method, you create a table of annual cash flows from the asset added to its salvage value. The chart at the bottom of this page is an example of an asset investment of $30,000 with an annual cash flow of $5,000 and a salvage value of $15,000. We’ll keep the salvage value constant to simplify the calculations.
Each year, $5,000 is added to the total cash flow from the asset. The salvage value is added to this cumulative cash flow to get the cumulative total. When the cumulative total equals your investment of $30,000, you have reached the end of the payback period. In this case, the payback period is three years. This method focuses more on risk protection than simply cash payback, so the results will vary from the first method.
Predictions are always imperfect, but using an analytical approach will balance the emotional aspects of purchase decisions. Simple methods such as these improve your chances of choosing fixed asset investments that minimize risk and maximize your future profitability.