I/EC
Costs
Economic Considerations in Postponing Investment A method of determining how long to put off a deferrable investment by Harry A. Quigley and James B. Weaver, Atlas Powder Co.
r \ COMPANY is frequently faced with the opportunity to make an investment in facilities before they are needed to satisfy capacity requirements. Almost every old piece of equipment develops high maintenance and operating costs. T h e new machine presumably will have lower costs. I n addition, there might be intangible benefits, such as increased safety. Management might be tempted to install the new machine earlier than actually needed so as to obtain these benefits. This column discusses the factors involved in determining when such machines should be installed earlier and presents a method of quantifying the economics to help management make the decision. Factors Favoring Delaying Investment
Increased Return. Since the new equipment is not needed to meet sales forecasts, no additional profits on sales are generated during the period of early investment. There is, however, some savings from reduced operating a n d maintenance costs. T h e total profit is reduced when the earlier investment is made with a corresponding reduced profitability of the investment. Alternative Investments. The funds " e a r m a r k e d " for the new equipment could be invested in alternative profitable projects during the period the investment is deferred. These alternative profits depend on the return available on other projects and the length of time the investment is deferred. They are offset somewhat by the higher operating a n d maintenance costs with the present equipment. This assumes that the company has more investment opportunities than it has capital. It might be that the company has not exhausted its borrowing power. In this case,
the funds made temporarily available by deferring the investment cannot be credited with the return on alternative investments but only with the after-tax savings due to avoiding interest expense. Deferral of Later Replacements. T h e equipment will have about the same useful life regardless of when it is installed. Postponing the investment delays the time when the next replacement and all subsequent ones are needed. Technological Development. Presumably the new equipment is superior to the old equipment due to technological improvements. Still newer equipment could be developed in the period before the added capacity is required so that the proposed unit, if installed, would have undergone some obsolescence by the time additional capacity is needed. Improved Forecasts. T h e sales forecast, which indicates the need for the new facilities five years hence, is subject to uncertainties, as are all forecasts. These uncertainties are less for short-term than for long-term forecasts. If the investment is deferred, the forecast indicating the need for new facilities will change, relatively speaking, from a long-term to a short-term forecast. It will become correspondingly more reliable and will permit a more realistic pinpointing of just when the new facilities will be needed.
Factors Favoring Early Investment
Inflation. Equipment costs have increased steadily and it is likely that this will continue. If the investment is made before it is needed to meet sales demands, it can probably be made at lower cost than if it were deferred.
Immediate Savings. Reduced operating and maintenance costs represent savings which can be immediately realized if the new equipment is installed. T h e added capacity may reduce overtime labor, providing additional benefits. Sales Protection. T h e increase in capacity will provide a margin of safety in meeting short-term sales fluctuations. Unusually large orders, the seasonal nature of the business, and other factors may combine to exceed temporarily the capacity of the existing equipment. Thus, while the increased capacity is not required for yearly demand for five years, it might be required to meet short-term demand. Safety. Operating conditions may be safer with the new equipment. T h e existing equipment, being of an older design, may not embody the safety features of the new equipment. Also some of the safety devices may have been broken and not replaced. Morale. T h e new equipment may be much easier and more convenient to operate. T h e morale of production personnel may be increased considerably by the installation of the new equipment.
M a k i n g the Decision
As the above discussion points out, there is a conflict between those factors favoring early investment and those favoring later investment. T h e factors favoring early investment are mainly intangible and no direct economic value can be assigned to them. Management is always deciding whether or not to make an investment at a particular time, regardless of whether it is specifically considered. I n this case, inactivity is equivalent to a decision to defer the investment. Postponing the investment normally has all the effects VOL. 52, NO. 11 ·
NOVEMBER
1960
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COSTS discussed above. T h e return on the particular project being studied during its delayed life is increased, and alternative income may be realized on other investment before the project begins. This alternative income can be compared to the intangible benefits realized by early investment. Management then has a quantitative estimate of what it costs, in the form of lost alternative income, to obtain the benefits of early investment. Interest rate of return gives false or multiple answers when used in comparing alternatives which differ only in the timing of cash flows. It can be used to determine the profitability of the project, during its life, compared to a base case of not investing at all, but it cannot be used to study the deferral of the investment. Other simpler return criteria, such as return on original investment, by their nature ignore the timing of cash flows and cannot be used. T h e basic inadequacies of return on investment techniques render them unsuitable for deferral decisions. W h a t is required is a method which converts the various cash flows during the allowable period of deferral into a simple measure. This method should take into account the timing of cash flows and quantify them into a measure of the cost or saving in deferring the investment. This cost or savings can then be balanced against the intangible factors involved. T h e value of the cash flows before the project begins can be expressed as a uniform annual payment (UAP), using compound interest techniques. This technique is described in "Principles of Engineering Economy" by E. L. Grant and W. G. Ireson and also in other engineering economics texts. T h e U A P technique converts the cash flows representing the acceleration of the investment, any savings realized by early investment, and lost income on alternative projects into a yearly sum which is equivalent to the cost or savings during the period that the investment could have been deferred. Use of U A P permits cash flows with various time characteristics to be compared. T h e U A P approach is based on present values (PV), which can also be used. T h e advantage of U A P over PV in this application is that it expresses benefits as a 58 A
yearly cost. Therefore, it permits management to compare the benefits obtained from early investment with a given yearly sum. Thus, a cost can be imputed and management will know what it is paying for the benefits. T h e concept of U A P and its application can be illustrated by the following example. Assume a company can make an investment of $100,000 in new equipment now that will not be required to meet sales demand for five years. Early installation will reduce maintenance and operating costs $12,000 before taxes or $6000 after taxes in the first year after the investment. This savings is estimated to increase uniformly to $9000 after taxes, in the fifth year. For simplicity, both inflation and depreciation cash flows will be neglected in this example. There is a $30,000 total savings in out-of-pocket outlays if the investment is made during the first year rather than at the end of five years. However, these out-of-pocket outlays neglect any profits which could be realized on alternative investments. At worst, the $100,000 could have been invested in government bonds returning 4 to 5 % per year, for the allowable period that the investment can be deferred. In practice, assuming the company is limited by available cash, investment opportunities will be available returning more than 4 to 5 % per year. If these available investments are assumed to return 1 0 % per year, the company is foregoing this return by making the investment before it is needed. It can be seen that, even before compounding, these alternative earnings will exceed the savings available from reduced operating and maintenance costs. T h e table shows the differential cash flows if the investment is deferred for the full five years, with parentheses indicating net cash outlays. T h e ($109,000) in year 5 is the sum of the $100,000 investment outlay and the $9000 potential savings which are not realized.
INDUSTRIAL AND ENGINEERING CHEMISTRY
Year 1
Cash Flow, $ 100,000
2 3 4
(6,000) (7,000) (8,000)
5
(109,000)
W h e n the series of cash flows is converted to an equivalent series of U A P using compound interest, it is found that deferring the investment results in a net gain to the company of about $2400 per year during each of the five years that the investment is deferred. This is the same as saying that investing now, rather than when needed, costs the company $2400 per year for each year the investment could have been deferred. This $2400 per year can be presented to management as the cost of obtaining all the intangible benefits which might be realized from having the new equipment available at an earlier date. This U A P gives management a yardstick to measure their "feel" for how bad the new equipment is needed. Even though no economics as such can be attached to the intangibles the dollar figure will help them know whether their cost is too high. Intermediate Deferral
I n the example shown, the investment was to be made immediately. Presumably it could be delayed for any period of time u p to five years. If management decided that $2400 per year were too much to pay for the other benefits, they might examine a shorter deferral period, say three years. In this case, they would find the cost of making the investment would be $1300 per year for each of the two years that the investment could have been deferred. This compares with $2400 per year if the investment were m a d e immediately. T h e reduction of $1100 per year in the cost of accelerating the investment might be enough to make management decide to reconsider the investment after three years rather than waiting the full period until the equipment is needed to meet forecasted sales.
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