To Buy or Not to Buy?
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Q: How can I determine if purchasing a large piece of equipment for my business is worth the investment?
A: Every day, individuals and businesses ask themselves that very question: Should they buy that piece of equipment, invest in a business or buy that stock? There are many factors that go into making investment decisions. One of them should be an analysis of the ROI.
Simply stated, ROI is the cash that you get back (or save) by purchasing any asset (including equipment and stock). You would compare ROI of an asset with the ROI of alternative assets. If the ROI of an asset does not meet your criteria, perhaps you are paying too much for the asset or you should not invest.
The logic behind the ROI calculation is: Will the annual (after-tax) cash flow generated over the life of the asset, plus the after-tax proceeds on the future sale of the asset, be enough to justify the cash outlay necessary to purchase the asset today?
You should note a couple of things in the above statement. First, the analysis should be done on an after-tax basis. This is because income tax must be paid on income and any gains from sales; therefore, to ignore taxes would result in an overstatement in the ROI. The second thing is that we must account for the fact that income and gains will occur in the future. A dollar today is worth less than a dollar will be worth five years from now--because of inflation and because of the opportunity cost of buying one investment and not the other.
Expressed in a formula, ROI is calculated as follows:
ROI = -PV + ? (Y x (1 - t)) / (1+r)n + ? D x t / (1+r)n + FV/(1+r)n - ((FV - NBV) x t )/ (1+r)n
PV = Purchase price of the asset
Y = Income (or savings) over the life of the asset
D = Annual depreciation
r = Risk-free rate
t = Tax rate
n = The life of the asset (or hold period) in years
FV = Future Value of the asset when sold (or salvage value)
NBV = Book value of the asset after depreciation
If you divide the ROI by the PV, you will get the ROI percentage.
The ROI formula can be broken down into four parts. The first part, -PV, represents the cash outflow for the asset. The second part, ? (Y x (1 - t)) / (1+r)n, reads as the sum of after-tax income generated from the asset over the life of the asset. You will note that the annual income is divided, a number that grows every year to take into account the time value of money. The third part, + ? D x t / (1+r)n, reads as the sum of depreciation tax benefit received over the life of the asset. The fourth part, FV/(1+r)n,, reads as the present of the cash received at the end of the asset's life. The last part, - ((FV - NBV) x t)/ (1+r)n, reads as the present value of the taxes when the asset is sold.
You can see that a fair amount of guesswork goes into this calculation (such as future income, salvage value and so on). When determining these variables, it is better to err on the side of conservatism.
There can be numerous variations to the above formula. For instance, in the example above, the company may finance the purchase, which would change the calculation.
Finally, ROI is only one factor in making investment decisions. Other factors include available financing and operating factors such as available labor and facilities.
Ian Benoliel is the CEO of NumberCruncher.com Inc., a developer of budgeting, manufacturing and management software for entrepreneurial businesses. NumberCruncher combines its accounting and finance expertise with technological know-how to deliver software that is affordable and easy to use, yet sophisticated and powerful. More information on the NumberCruncher's products and services is available at www.numbercruncher.com. Ian has nearly two decades of business, accounting and financial consulting experience. He has advised corporations on business plans, financial projections and accounting computer systems.
The opinions expressed in this column are those of the author, not of Entrepreneur.com. All answers are intended to be general in nature, without regard to specific geographical areas or circumstances, and should only be relied upon after consulting an appropriate expert, such as an attorney or accountant.