How Long Should it Take to Pay for a New Asset?

Ladder Racks

Ladder Racks (Photo credit: dmitrybarsky)

One common question I get is “How does a company determine how long it should take to get back a capital investment”. I get this question concerning all types of investments – the investment to add one customer, the investment to add a new product line, the investment to expand to a new town. While the answer is different for every company, the way that you look at the issue is the same for everybody. I think you need to look at the following factors in determining what is right for your company.

Revenue Generated. It’s easier to answer this question if you are building an asset that directly contributes to generating a specific new revenue. For instance, if you build to a new customer’s house or build to a cell site, the revenues from that new location can be directly attributable to the assets being added. But things aren’t always this clear. For instance, you might be adding a new router that contributes to many existing revenues as well as enables some new ones. Or you might be doing an upgrade on a cable headend that will make the product marginally better but that will probably not attract new customers. The more direct the relationship between a revenue stream and an asset, the easier it is to talk about paying for that asset.

Margin Generated. Once you have determined the revenues associated with a given asset, you then want to look harder at the margins on those revenues, because it is only the margins that can be used to recover the cost of the assets. For example, if you pay 50% of you cable revenues for programming, then you only have the remaining 50% of margin left that can be used to recover the cost of an asset that is used to supply cable TV. I very often see companies be too simplistic and say such things as a new revenue will pay for itself in two years. But when you look at the facts they often mean that they will generate enough gross revenue to equal the cost of the asset, but that is not the same as having generated enough margin to actually have recovered the cost of the asset.

Financing Term. If an asset is financed with debt, then you can stretch the recovery of the asset for as long as the term of the debt if you want to. That may not be the best business goal, but you don’t really pay for the asset until you make the debt payments. One thing that is important though, is that if you finance an asset you need to add the interest and other financing cots to the cost of the asset.

Contract. Sometimes you will have a contract specifically designed to recover the cost of an asset. For example, if you build fiber to get to a cell tower and get a 5-year contract bandwidth at that tower, then ideally the revenue generated at the tower will pay for the asset within the five year term of the contract. You should think about breakeven and profitability as if the contract will not be renewed.

Churn. Companies often fail to consider churn in looking at the recovery of assets. For example, supposed you are building a fiber network to a new town, and further suppose that you have a 10% churn of customers each year. In such a case, you need to factor in this churn in looking at whether you can recover the cost of adding drops and electronics to customers. While you may have some customers who will last ten or more years on the network, there also will be customers who drop off in the first and second year and will strand some of your new investment without any compensating revenue stream.

Tolerance for Risk. This is the most intangible item on the list, but often the most important. It is important for each company to be realistic about their tolerance for risk. For example, a company that doesn’t have much access to debt and which must pay for new assets out of current cash flows has a much lower tolerance for risk than a company with deep pockets or an open credit line. The first company really cannot afford to make any mistakes in rolling out new investment and they also need to recover any investment made faster than the second company.

A company needs to take all of these factors into consideration. There is no industry-standard answer to the question, but there is a right answer for everybody. A lot of the answer comes back to the last bullet point – in your company, when are you going to need the cash back from an investment in order to make another investment?

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