Navigate the complexity surrounding CAPEX and use our free template to make better decisions.
The complexity surrounding capital expenditure (Capex) plans is a challenge to Finance leaders charged with directing a company’s strategy. Capex plans are crafted for a 5- to 10-year period and underpin your company’s long-term growth trajectory. If you plan on increasing sales revenue, you need to plan Capex to support this growth. Simple enough, right?
Of course not! Economic disruptions like Covid-19 can scrap the best laid plans overnight. For example, in retail industries, the pandemic has accelerated the demand for companies to directly interface with customers, and thus spurred on the Direct-to-Consumer (D2C) business model.
Do situations like this necessitate additional investment or demand Capex austerity? These are complex questions that Finance and the executive team need to have a handle on; making fleet-footed decisions confidently can only be done on the back of an accurate Capex forecast.
Let us continue with our e-commerce example. Founders face limited barriers to entry to starting an ecommerce business. Many companies are ready to support a company’s packaging, shipping, and distribution needs. But doing the same thing as the competition doesn’t confer a distribution advantage in the long run, so it’s worth considering changing tack.
An alternate strategy would be to bring these operational capabilities in-house and plan for upfront capital requirements while also keeping an eye on long-term financial effects. But a big commitment is a risk of its own. A business owner will also want their plan to incorporate the flexibility to change this strategy (realizing an asset’s value on its balance sheet and being able to liquidate it) should another significant economic shock require them to once again tear up the playbook.
We created a Capex forecast template to help companies make strategic capital allocation decisions.
To see how it works in action, consider a fictional company, BrickAndCyber, operating in the Food and Beverage (F&B) sector. We’ll use BrickAndCyber to walk you step-by-step through how to think about your Capex plan and show how OnPlan’s Capex forecast template supports the Capex budgeting process.
BrickAndCyber is a food startup that, after having gone the brick-and-mortar route, has gained more traction by distributing through national grocery chains. They are considering a D2C play, and weighing the upfront capital required to execute this strategy. They also need to decide when to purchase each asset and the best way to absorb the costs of these assets over time.
Their CEO wants to know: will investing in an in-house fulfillment center support their future revenue growth? (For the purposes of this example, we’re considering the costs only).
Let’s lay out the base case scenario.
We apply OnPlan’s Capex template to analyze the costs of Brick&Cyber in undertaking the Case 1 option. Let’s begin with the assets required and the cost involved before going into the nuances of how this affects the company’s discretionary asset expenditure.
In Capex budgeting, the purchase value of the asset is one consideration in the process. But in fact, there are various elements that interact with the asset. Viewed from the point of view of your company’s accounts, those interactions could change your appetite to proceed with a given asset purchase. These elements are listed in the columns above. They cannot be considered individually because of the interdependence between them.
For example, whether you can write off an asset is dependent on if it will be used in your business’ core operations. Your tax consultant would give you guidance on what the correct capitalization percentage is. From a timing perspective, the asset may be determined to have a useful life of seven years, but this figure is a moving target and determined by the depreciation method chosen.
BrickAndCyber has prioritized the order in which the Capex purchases will take place. The first asset — the warehouse — is purchased in 2022. The lion’s share of the remaining investments are undertaken in 2023. From here, it is up to management, and in certain cases IRS rules and regulations, to determine the method in which the company will absorb these assets on their balance sheet.
The difficulty for an organization’s Finance leader is that the same depreciation treatment needs to be applied to all assets that fall under an umbrella asset class. For example, the purchase of a new office would, along with the warehouse, fall under the ‘Buildings’ asset class. OnPlan’s Capex template cuts out this complexity by applying the same depreciation method that has been stipulated for the asset, even if it has a different useful life. This situation commonly arises when a subsidiary of a business applies a longer period to an asset that its parent would.
In determining taxable income, your company’s earnings (EBITDA) is reduced with depreciation charges. With this we arrive at the Earnings Before Tax (EBT) line item on the income statement which, as the name suggests, will be the amount on which your tax bill is calculated. It’s clear then that depreciation has a considerable bearing on the timing of tax payments – but knowing this, how do you select which method to choose?
All too often, businesses write off an asset as quickly as possible to reduce their immediate tax burden. Theoretically, that makes sense – a dollar of tax paid this year decreases your company’s value to a larger extent than a dollar of tax paid next year.
But in practice, shortening your depreciation schedule and accelerating the deductions isn’t always the right approach. As it usually is, the right approach is the one that is appropriate to your business and context.
Back to the case of BrickAndCyber. An accelerated depreciation schedule is helpful for startups and indeed all businesses in their formative years of operations – a timeframe that is often characterized by cash flow constraints. By making higher deductions now, these companies reduce their current tax bill and can reinvest these tax savings back into the company to supplement growth.
But this is not taking into consideration the business’ context. Other factors need to be considered too, none more important than revenue. For example, if BrickAndCyber projects that its revenue will increase rapidly from the medium-term onward, it may place the company in a higher tax bracket.
The company then can’t afford to be left without assets to offset their income during this time. Their finance leads will need to evaluate what methods will leave them with the highest depreciable amounts in the period where revenues are high and they need to lower their tax bill.
This requires them to consider multiple depreciation treatments on various assets simultaneously. It’s an arduous task that calls for a sophisticated model to do the heavy lifting.
For Brick&Cyber, it follows that the company chooses a conservative depreciation method that will give them the leeway to offset income in a later period. This can be seen for both existing and planned assets, where the depreciable allowances are – by design – the largest across the 5 – 10 year period.
In a similar way, if you are applying the OnPlan’s Capex forecast template to your company, the template serves as an extremely helpful tool to analyze the effects of multiple depreciation treatments across asset classes.
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