Capital expenditures are at the heart of any company's future. Unfortunately, almost all industrial companies get capital expenditures (capex) wrong. Why? Because capex projects aren't considered within a broader perspective of the company's long-term strategy, its total production footprint, customer expectations, and the overall marketplace.
In this article, we explain the right way to create a long-term capex strategy.
THE PROBLEM STARTS HERE
Different companies have different ways to measure the value of a capex project. Some use net present value (“NPV”) or an internal rate of return (“IRR”) while others may simply use payback periods or some mix thereof. Regardless of how they gauge performance, every company we've ever worked with or heard of uses metrics based on one common principle: the difference (or “delta”) between a production asset's cash flow with the capital expenditure and the asset's cash flow without it.
A HYPOTHETICAL EXAMPLE
We've found the most straightforward way to explain why cash flow deltas are misleading is to use a simplified illustration of a hypothetical company with three production sites. Let's say Quality Pulp Manufacturing, Inc. has three pulp mills. Its Baton Rouge, Louisiana, mill has been in operation for about twenty years. Quality Pulp assumes the mill will maintain its operations for the foreseeable future as it has over the last twenty years. When we graph its normalized cash flows over the last few years and project them into the future, it results in the following graph:
The executives at Quality Pulp expect that Baton Rouge will require a number of capexes over time. Machinery and equipment wear out, the market expects a certain level of quality, and so forth. In
