Replacement versus investment capex: striking the right balance

November 2, 2016

When it comes to managing capital expenditure (capex), many firms don’t adequately consider the mix between replacement and investment capex. Instead, they allow strategy, project portfolio, available resources or M&A activity to drive spend in this area. So what is the right approach to finding balance between spend on replacement and investment capex?

In most industries, replacement capex constitutes the bulk of the total capex budget. This is understandable as core assets, which are critical to a firm’s ability to operate, need to be maintained so a business can continue to operate at steady state.

The unfortunate consequence of this situation however, is that it limits the funds available for investment capex, which has the potential to expand operations, improve productivity and increase profits. Further adding to the situation, many companies base investment capex decisions on isolated, bottom-up requests rather than planning appropriately year-on-year.

How capital planning can strengthen capex decisions

Finding the right balance requires a cohesive and iterative process. Comparing replacement capex levels year-on-year can help businesses track the success of their asset management programs and the lifecycle of the assets themselves. Global management consulting firm, A.T. Kearny suggests that substantial savings may be achieved by switching from time to risk-based replacement cycles. This involves replacing assets based on the risk they pose to profitability rather than the amount of years they have been in service.

In addition to this, an optimal capital planning strategy will take regulatory and budget constraints into account.

Once an appropriate level of replacement capex is determined, based on benchmarking and risk-based asset management, additional elements, such as M&A and growth capex, can be incorporated into the overall strategy to compete against each other.

A.T. Kearney notes that few companies seek to determine how much cash they need to fund qualifying projects, that is, a project that has been determined to be good for business. Instead, most favour an approach based on historic data and high-level benchmarks. This approach risks cutting out numerous value-adding projects before they ever get off the ground.

Furthermore, in seeking to deliver innovative, value-adding projects, CFOs should avoid focusing on measures such as net present value (NPV) and hurdle rates as a basis for capital decisions. As the famous former boss of U.S. giant General Electric, Jack Welch once said: “Most innovative ventures die from overly high profit hurdles.”

A.T. Kearney suggests allocating 10 to 20 per cent of the total growth capex budget to projects that do not meet valuation hurdles, provided they offer high strategic relevance and options for upside potential.

This leaves room for innovative thinking and gives businesses the opportunity to explore different methods of strategic thinking.

A closer look at the Australian landscape

While balancing replacement and investment capex is important, recent data suggests that Australian businesses aren’t even reaching sufficient levels of spend on replacement capex, let alone investment capex. The October 2016 Alleasing Equipment Demand Index found that 60.6% of businesses are predominantly stagnant in terms of equipment, plant and machinery acquisition intentions. This is furthered by insights into the industries suffering the most from overdue equipment replacement impacts— agriculture (97.3%), mining (97.8%), manufacturing (67.4%) and energy (63.7%).

The survey also showed a clear trend away from outright equipment purchasing, which dropped from 29 per cent to 15.6 per cent during the two years since the inaugural index. Instead, businesses are increasingly favouring operating leases (30.7 per cent), finance leases (12.7 per cent) and chattel mortgages (10.6 per cent), which suggests Australian companies have recognised the need for more innovative finance solutions, such as switching capex into opex through flexible finance solutions.

While this trend is positive, given the extent of businesses impacted by outdated equipment, it will likely take some time to restore appropriate levels of spend on replacement capex. This means spend on investment capex is also likely to suffer at least in the short term unless businesses seek innovative ways to fund to meet their needs.

Capex is one of the major drivers of long-term profitability thus, optimising capex spending is crucial to business performance.

By closely examining the both the drivers and results of capex spending, it is possible to strike the right balance between replacement and investment capex. In addition, properly utilising modern-day funding solutions has the potential to improve business performance.

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