Capital Projects – lease or purchase

There are many ways to skin a cat, more ways to generate value and near infinite manners to assess investments’ value creation potential. Business needs to be boiled-down to the basics to get a holistic view of how value is determined and thus how it can be created. The fundamental purpose of business is the supply of value adding goods and services in exchange for other value adding goods and services, with currency as an exchange medium and value store. A transaction would not take place if both parties did not see value in partaking in the exchange. Value is the interpretation of a perceived benefit materialising from some tangible or intangible item or event. One of the main reasons why trade occurs is due to businesses having different core competencies and thus more efficiently creating goods and services which fall into their core competencies. These goods and services can be split into smaller useable quantities for other businesses to purchase and use. This comparative advantage illustrates how both parties can mutually benefit from cooperation and voluntary trade resulting in a higher total output for the same collective capital and labour employed. By taking a comparative advantage view, a business can focus on their core operations solely while relying on external companies’ expertise to provide secondary support, resulting in the highest output and profit for the amount of resourced employed.


What about core capabilities, focus and strategic drift?

In an extreme example, a baker could have his own land, grow his own wheat, process the wheat into flour and bake the bread, not to mention all the other components and parts he would have to make to be fully self-sufficient. These options are all possible but would be costly, complex and time-consuming. A better process would be to stick to his core capabilities and buy processed flour, an oven with a proven track record and guaranteed electricity and have his only task be baking the bread, the net output being more bread produced at a lower unit cost due to the lower complexity of operations. Of course, with the right scale and in the right circumstances, insourcing some non-core functions might have higher nominal returns.


Projects as a source of earnings?

In a more corporate sense it is management’s primary goal to provide long-term, sustained value generation for the entity’s shareholders. From financial basics: To add value to a business, management must only invest in projects which have a positive net present value at the business’s weighted average cost of capital(WACC). If a project has a negative net present value at its WACC rate, the cost of the finance employed is greater than the earnings generated, thus the project will erode company value. Projects generally also need to make required returns within a certain time-period. If a company has an excessive retained earnings account with no upcoming projects meeting the above criteria, then management should make a dividend distribution to shareholders so that the shareholders can invest the surplus earnings in other profitable ventures. The above process is known as ”capital budgeting”, it is maximising returns by selecting the combination of highest earning mutually exclusive projects given a limited equity budget and upper-bound debt limit.


Strategic time-frames for decision-making?

Most executive decision makers tend to be in the later portion of their careers with less than 10 years of service remaining. The benefits of their decisions on projects with long lifespans and long paybacks will be out of their tenor. An additional challenge is that the budget available for new capital expenditure on non-core business is usually very minimal. Some financing mechanisms allow for zero upfront investment while achieving benefits from the onset of a project. Power Purchase Agreements (PPAs) are such an example. PPAs allow the benefits to be realised from day one without any capital expenditure being incurred. Independent Power Producers (IPPs), through PPAs, clearly quantify the cost of energy for their clients over a set period, thus reducing the risk by hedging a portion of a client’s energy needs.


What about cash flows?

In nominal terms over the life of the asset, the net savings of a capital expenditure funded build will be greater than the nominal savings from a PPA if the inherent cost of the utilised capital is not taken into account. However, when taking cashflows discounted by the off-taker’s WACC rate into account for a defined period, a PPA will likely be better, depending on the different cost of capitals of the respective parties and input costs. Entering into an agreement in which an IPP’s economic goals are aligned to the off-taker’s ensures that the most economically efficient production is made from the energy plant. The financial position of the company also needs to be taken into account with regards to the desired leverage rate, cash available and shareholder desired investment horizon. One also needs to take the level of risk into account related to the decision to outsource or insource. In essence, adding value translates directly into getting more bang for your buck, i.e. a higher percentage return per Rand invested. One needs to find a balance between total quantum of return and percentage return, given an inherent cost of capital employed to this end while realising the benefit in an acceptable time frame.

By Louis van Wyk