One of the most fundamental requirements of the capital budgeting process is determining the right time to switch from maintenance of existing assets to replacement so that the business can bring more productive critical infrastructure into play.
This process has two primary goals:
So, any decision about allocating capital needs to keep these two aims in mind.
Whilst the right approach will be different for every business and will depend upon unique circumstances, there are a few considerations CFOs can use to help guide the decision making process. These are:
1: Driving returns
When assessing whether to invest in investment infrastructure or updating existing equipment, there are three possible methods to help establish potential return:
The method you choose will depend on the nature of the infrastructure and the business’s preference for assessing potential performance. However, the intent is to assess the short and long-term cash flow implications that existing and potential new infrastructure to produce, taking into account its age.
2: Access to capital
The second consideration is access to capital. Supply is limited for every organisation and a business’s unique ability to access capital will depend on the strength of its balance sheet and existing funding arrangements.
One of the ways to put the business’s available capital to good use is to rent rather than buy infrastructure. In this regard, there are a range of capital solutions available, including operating and finance leases.
3: The business and economic outlook
One of the main considerations when balancing replacement and investment capital is the outlook for the business, the industry it operates in and the overall economy.
When the economy is expanding and the outlook for growth is positive, businesses may take the decision to invest in new infrastructure to help drive profit. If the decision to invest in infrastructure is taken then it’s important to make a realistic assessment of the opportunities the business can access by making that investment.
Competitive threats are another issue the business needs to consider before deciding to use capital to replace or buy new equipment. It’s important to research the way major competitors are approaching their investment decisions. Many public companies publish information about this as part of their financial reports. It’s more difficult to find this information about private businesses, but the activities of the listed businesses should give a good indication about the industry approach to investment at any given time.
Another key consideration is technology. Improvements in this area often give businesses a competitive advantage. Investing in the latest equipment, rather than maintaining existing infrastructure, may be one way to realise this advantage as well as increased profits and productivity.
Making the right choice
The right direction will differ for every business, and depend on many of the factors outlined above. The idea is to make an objective determination of the best way forward, always keeping in mind shareholder returns and the business’s strategic direction.
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