CFOs blend new and old techniques in a quest for capital budgeting solutions that allow more flexibility.
“Money is everything,” goes the old saw, and in the current economy, many U.S. companies are swimming in it. The pile of cash held by U.S. corporations is more than $2 trillion and growing, stoked by low-cost bond issues, stringent cost-cutting, and sizable profits. But success brings its own challenges, like the need to profitably allocate capital to meet the market’s elevated expectations for forward earnings, as reflected in healthy share prices. With activist investors, other shareholders, and financial analysts on constant watch, deciding whether an investment is worth funding is not a job for the fainthearted.
The task, of course, lands squarely in the lap of the CFO, who carries the banner for the business-planning process, “stitching together [the company’s] strategic growth plan and fundamental investment model, year after year,” says Mark Partin, finance chief of accounting software firm BlackLine. But in a domestic economy that is potentially overripe and expanding at less than 3% a year, CFOs can’t just stick to standard operating procedure.
They are also confronted by the changing nature of capital investment in the United States, trending away from new machinery, new manufacturing plants, and other “hard” assets to things like research and development, staffing, and software. In many industries, budgets are less about updating old equipment and more about improving customer service, launching new products, securing corporate networks, and bolstering worker efficiency.
As where the cash is going changes, of course, so must the techniques used to screen investment projects. Many CFOs, it turns out, still deploy tried and true capital planning techniques like net present value (NPV) and internal rate of return (IRR). But others find that they are relying less and less on the old formulas: when speed is of the essence, often a straight return on investment is all that’s needed. So, what methods and models are informing CFOs’ capital investment decisions in the 21st century? How are they making the critical choices that shape their organizations’ futures?
Over the past 20 years, capital planning has altered dramatically, says Ken Stillwell, CFO of customer relationship management (CRM) software provider Pegasystems, who was a finance executive at several tech companies over that stretch.
“In the old days, capital expenditures were fixed—you were told ‘here is your capital budget and here is your operating budget,’” says Stillwell. “In my world right now, the lines between the two have blurred. For us and many other software companies, capital planning is all about [deciding what cloud systems to use].”
Partin, BlackLine’s CFO, suggests long-term capex decisions have gone the way of packaged software. Like many tech firms, BlackLine has transitioned into a cloud-based software-as-a-service (SaaS) provider. “Traditional capex has now been concentrated on cloud operations,” says Partin. “I’m making short-term decisions on cloud applications—is this particular solution the right one to help us grow and invest in the right kind of people? Will it give us a return on our investment?”
BlackLine’s capital spend is directed toward cloud applications that enhance brand, marketing, data security, and field-sales capabilities. But the company eschews long-term commitments. Each of BlackLine’s cloud providers is signed up on an annual term basis, allowing for “quick ins and outs if we wanted that,” the CFO says. “We’ve distilled the capital planning process to ask ourselves if this is the right partner and the right investment.”
In handling decisions that way, BlackLine leans toward metrics like a vendor’s net promoter score (NPS), customer testimonials, and reputation instead of old tools like NPV and IRR.
The new metrics assist faster investment decisions, Partin says. “The cycle of innovation in the tech sector is so blisteringly fast and the threats to data so prolific that our investment decisions need to be equally rapid and agile,” says Partin. “Where we house our data, where we put our servers, what we put in them, and the systems we buy—all have to be able to adapt to new products, rapid growth, and new threats.”
Rigorous but Flexible
Speed and agility of decision-making is a common theme in capital budgeting these days. At Centage, a provider of automated budgeting and forecasting software, the process of analyzing capital spending is much easier now that the company has transitioned to a recurring revenue model with a predictable revenue stream, says CFO John Orlando.
The company’s costs for hosting its solutions have to do with capacity planning—figuring out how many servers and how much bandwidth it will need, which is driven off of sales forecasts, says Orlando. Capital decisions are based on revenue expectations—what kind of business Centage hopes to sell and where it will sell it. “If we strategically want to grow 40% this year, we look at the investments we need to make to support that; if we can’t afford the investments, we lower our growth goals,” Orlando says. In making investments in cloud-based applications, there’s no need to take into account each one’s IRR or NPV, Orlando says, “just the ROI.”
An example of such an investment was the adoption of expense reporting solution Concur. Previously, Centage’s consulting team spent 3 to 4 hours per week reconciling their expense reports. Now that the process is automated with Concur, it takes them less than 30 minutes. That equates to savings of 25 hours per week for people billing $250 per hour. Centage’s accounting team also used to spend 10 to 15 hours per month reconciling reports and chasing receipts; now the process consumes no more than 3 hours per month.
Instilling speed in capital budgeting is also key at Power Distribution, a manufacturer of electrical systems for corporate data centers. The company has invested in new product development; product extensions; acquisitions; R&D; factory capacity expansion; and people, its workforce growing 30% over the past five years. CFO David Hensley has to be able to alter this investment mix rapidly when circumstances warrant.
“The biggest challenge for us is how to create a rigid enough due-diligence process at the front end of our planning to make good business decisions, but have the process be flexible enough to allow for swift capital changes,” Hensley says.
Shifting resources quickly can be critical when many projects are fighting for a fixed pool of resources. CareCentrix, a home health-care coordinator, has had, like other services providers in its sector, a relatively flat capex budget for years, says Steven Horowitz, the company’s CFO. For some capital expenses, Centrix has no choice but to greenlight them. For example, it has to invest in projects to comply with health-care regulations, Horowitz explains. “There’s no need to do an ROI; we just try to do what’s needed for the least amount of money,” he says.
But for other projects, CareCentrix uses a fairly rigorous capital planning process that begins with a “project chartering” phase. That phase documents what the project is, the problem it is solving, what it will cost, and the value it will generate. Once a capital decision is reached, finance and the relevant department, function, or line of business review the progress of the project at a series of “gates” to determine whether or not to go forward.
“Before we go too deep, we make sure the assumptions are still correct,” says Horowitz. “We may have to put more money into the pot or pull some out and put it into a new opportunity.”
Horowitz relies primarily on return on investment to make decisions. Operating improvements and efficiency projects undergo a traditional ROI analysis, he says. “Other things, like a customer asking for a new capability, require a different analysis; [in those cases it’s] more about whether or not we should do it and what it would cost,” Horowitz explains.
For many companies and types of investments, the timing (of both the capital outlay and the return) still matters very much, especially when the expenditure is very large. For example, Pegasystems has approximately half of its operating systems on-premise and the other half in the cloud. The process for choosing one or the other takes into account the timeframe of the anticipated investment return.
“We look at the problem we’re trying to solve and how much variability we have in solving it,” says CFO Stillwell. For example, an ERP system is a 10-year problem that requires an upfront capital investment, he explains. But when investing in a new marketing automation solution, “where I have no clue what [the market] will look like 10 years from now,” Stillwell says, the answer is likely to be a SaaS product.
In making those decisions, Stillwell still performs a 15-year discounted cash flow, an analysis that projects the investment’s free cash flow into the future and then discounts this amount to arrive at a present-value estimate. The company’s financial planning and analysis group built Pegasystems’ DCF model, which requires significant post-calculation deliberations before finance doles out the funds.
Discounted cash flows, of course, are an important part of techniques like NPV and IRR that are used to evaluate new projects. Many CFOs still find substantial value in those formulas for certain kinds of expenses, even in the fast-moving tech space. Hodges-Mace, a provider of cloud-based employee benefits administration software, hinges its capital budgeting considerations to IRR and NPV outcomes, even though the company doesn’t do much in the way of traditional capital projects, says Ron Shah, CFO and chief operating officer.
For example, Hodges-Mace recently invested in a sales team expansion, adding more feet on the street and sales support personnel. “The plan was to grow what were 20 people in those jobs to 40 over the next 12 months,” Shah says. “We wanted to figure out the IRR on the investment before we took the plunge.”
Shah ran multiple scenarios, evaluating the profit potential of adding 10, 20, and 30 people over different time periods. The IRR results indicated the greatest opportunity would come from adding 20 additional sales and support people over a 12-month period, albeit 10 people in the second half of 2018 and the remainder in the first half of 2019. “This way we would see a return on the investment occurring in 2019 from the people that had already come on board in 2018,” he explains.
Another recent sizable investment—doubling the footprint of Hodges-Mace’s Atlanta office—went through a similar exercise. The company plans to lease an additional 15,000 square feet (in its existing building) over the next two years. “Although we won’t fully utilize all this space right off the bat, we learned from the analysis that it would be less expensive from a leasing standpoint to do one large expansion, as opposed to expanding gradually.”
In drawing this conclusion, the analysis took into account several factors, including the real estate market in Atlanta and Hodges-Mace’s expected 10-year growth rate. The projections compared short-term lease rates on a small expansion and long-term lease rates on an immediate, bigger expansion. The second option was more economical. “Plus, we would get an allowance for some tenant improvements to offset construction costs,” Shah says. It was a `no brainer.’”
Tom Liguori, CFO at Advanced Energy Industries, a developer of power and control technologies used in semiconductor manufacture, also uses an IRR model. [In the company’s industry,] “we all seem to have a lot of cash to invest and are looking at how best to deploy it—lining up our projects in a queue,” Liguori says. In analyzing R&D projects, “we’ll look at the technology we’re developing over a five-year opportunity period, insofar as the costs to develop it and the expected revenues [are concerned], and then do an internal rate of return,” Liguori says. “Every quarter we review these analyses to determine which R&D projects should be accelerated, changed, or killed.”
But IRR isn’t right for every situation. Aiming to achieve planning rigor with flexibility at Power Distribution, CFO Hensley relies predominantly on NPV (“our go-to”), since he thinks IRR is less flexible. “It’s harder with IRR to get a true apples-to-apples comparison if you have projects with different discount rates and risk profiles. It gets a bit wonky,” he says.
Hensley offers the following comparison: “Say we buy a piece of automation equipment to go in the factory. The probability of success in the IRR analysis will be really high. On the other hand, if we plan to launch a new product in a new segment outside our space, the probability of success will be the opposite. If you take this to the extreme, all we would ever do is automation projects, and we’d be out of business.” NPV, on the other hand, takes into account the need for “intelligent risk-taking,” Hensley says.
When Math Fails
As Hensley has discovered, the techniques of capital budgeting can be biased toward certain kinds of projects and rarely give CFOs all the answers. In addition, it is often the riskier, hardest-to-measure investments that can be most transformative for a company.
When weighing potential takeover deals, for example, Advanced Energy’s Liguori bases his decision on two hurdle rates—short-term and long-term. The short-term hurdle rate has to be equal to or better than a share repurchase over a five-year horizon. “We’ll compare a $50 million acquisition to a $50 million (stock) buyback, looking at the earnings per share in each case,” Liguori says. The long-term hurdle rate is the IRR on the cash flows generated by the acquisition. But Liguori can’t always go with what his hurdle rate analysis dictates. “We don’t want to be five years down the road and [realize] all we did was buy stock,” he explains.
Pegasystems’ Stillwell faces similar situations: the large, upfront bets can’t always be avoided. “We don’t always pick the project the DCF says makes the most bottom-line sense,” Stillwell explains. “If three potential capital projects break even from a DCF standpoint, meaning we shouldn’t invest in any of them, but one of the projects has considerable strategic upside, we’ll take it on. Even though we know we’ll lose money initially, we have to do it.”
Pegasystems’ April 2016 purchase of OpenSpan, a provider of robotic process automation software, was a case in point. The DCF model told Pegasystems’ management to abandon the deal. “[The model said] it was too risky,” says Stillwell. “But we knew it was critical insofar as where the market in enterprise CRM is going. In that case, quality trumped the math.”
Fear of Failure
Even when the models say an investment deserves a green light, stronger forces may discourage an organization from moving forward.
Since the recession, functions like finance, risk management, and procurement have been “in ascendancy,” says Tim Raiswell, finance research leader at CEB, a research firm. One effect of that: People generally don’t get fired for being too careful, for cutting back on spending, or for not spending in new areas. Those are “default behaviors” at a lot of companies now.
So, what prevents the larger companies from taking the actions necessary for growth? CEB, which has been looking at this for years, has identified four major categories of what it calls “growth anchors,” in the sense that an anchor weighs down a ship and prevents it from moving. One anchor is what CEB calls the “dangerous to fail” anchor.
The dangerous-to-fail anchor involves the role that negative consequences have in discouraging risk-taking. Given human nature, it may be unreasonable to expect managers to take risks that could stimulate growth if the penalty for failure is harsh.
“Executives feel they have to hold people accountable, but there should be a way to do that without sending a cultural message that it’s one or two strikes and then you’re done in the organization,” Raiswell says. “Some organizations get into very difficult conversations that feel like public trials.”
In some cases, a CFO or CEO may pay a price for a project that goes awry. But Raiswell says accountability typically is swifter and more material further down in the organization, “where it’s easier to draw lines between a project failure and human agency.”
If a project or growth investment isn’t performing, consider whether the causes are controllable. That type of evaluation requires infrastructure processes that track progress and ask whether the original assumptions about why a project would win were accurate.
“That takes discipline to do, and maybe some additional financial resources to capture that information,” says Raiswell. “Once the leadership team has that information, they can do a post-audit to talk about what was learned and what to [change] in the future. And the idea is then to reward people for putting their best foot forward on the project that failed. That’s how you start to build the right muscle.” —David McCann