Ask the Expert: Does it make sense to invest capital in facility upgrades?
Businesses have been challenged by volatile financial markets and revenue shortfalls since the COVID-19 pandemic began. As a result, the need to preserve cash flow has rarely been greater. Reducing costs is the logical first step.
It’s difficult to comprehend just how much technology changed over just a few years. Consider this: ten years ago you didn’t own an iPad, couldn’t hop in an Uber or even browse the web on Chrome. Airbnb didn’t exist, neither did Instagram, Venmo or GPS on iPhones. And the only thing most watches did was tell time. We’ve seen the rise of Artificial Intelligence, the Internet of Things, and Blockchain. Cars are driving themselves, packages ordered from Amazon are delivered within hours and, if you’re puzzled by, well anything, all you have to do is ask Alexa.*
One other revolutionary change that might not come immediately to mind is the rise of “as-a-service.”
Until very recently, businesses tended to think of assets as something that they owned, operated, maintained, and replaced when they’d outlived their usefulness. Their value and performance depreciated over time. As the name implies, “as-a-service” replaces the costs, commitments, and hassles associated with ownership, with a set of services that a company integrates and consumes as needed. Assets can be taken off the balance sheet and managed as an operating expense.
As such, as-a-service helps companies become more efficient, reduce costs, boost adaptability, and streamline workflows. Companies can select and combine services from best-in-class providers that support their very specific needs. When a system or asset is no longer effective, they can adapt it or replace it. As-a-service offerings can be monitored and evaluated by their financial performance in operational terms — productivity and results measured against cost — rather than by return on asset costs and the costs of maintenance.
Sounds good, right?
But, is “as-a-service” the right choice when you’re considering facility upgrades for your company?
Don’t ask me. Seriously. But I know someone who can explain the best use of company capital – and when as-a-service presents a better alternative to capital investment.
Cassandra Moore is the Corporate Controller for Centrica Business Solutions, North America. She has a B.S. in Account and an M.B.A with a concentration in finance from Sage Graduate School.
Cassandra, help us understand best practices for managing capital
“Traditionally, internal capital should be invested back into the business for anything that’s going to generate revenue in the future – whether that’s hiring more people, expanding locations, upgrading facilities, streamlining manufacturing, expanding or growing inventory, machinery/equipment, raw materials, etc.”
What factors should a company consider before investing in goods and services that support their core business?
“The first thing to consider would be the cost of capital and the company’s Internal Rate of Return (IRR) Threshold.”
Can you explain ‘cost of capital’?
“Look at it this way: There are basically two options a company can take if they’re looking for funding: one is to borrow money from a debt provider (think bank or lender) and the other is to sell company stock to investors (equity holders).
Banks make sure they’re well protected. The loans they provide are normally well secured, with a number of covenants (rules, conditions, restrictions) that dictate things like: how much a company can borrow, what the money can and cannot be used for, how the loan needs to be paid back, what happens if the company fails to pay it back, etc. Secured loans from banks are, accordingly, the lowest cost of funding. Currently, secured debt has interest rates of around 5% or 6% for stable companies with good borrowing history.
Investors, on the other hand, face considerable risk. They could, potentially, lose all their investment. So, the return on equity is generally higher than banks – something around 10% today. And, of course, the riskier the company the higher the cost of funding.”
How do companies determine their IRR threshold?
“A company’s IRR is, essentially, a guideline to determine whether to proceed with or pass on a specific project or investment. Assumptions about the costs of equity and debt, overall and for individual projects, profoundly affect the type the investments a company makes. Expectations about returns determine not only what projects they will and will not invest in, but also whether the company succeeds financially.
For example, if the internal rate of return on a project is greater than the minimum required rate of return – which is typically the cost of the capital – then the project or investment should be pursued. Conversely, if the IRR on a project or investment is lower than the cost of capital, then the best course of action may be to reject it.
If a company borrows money from the bank they can expect to pay around 5%. Their expected return on equity capital (investor funding) is usually around 10%. How you blend those two becomes their weighted average cost of capital.
So, let’s say a company uses a 50/50 split of debt/equity funding. That equates to 50% of 5% and 50% of 10% -- for a threshold of 7.5%. Meaning, if the company’s not earning their cost of capital (7.5% in this example) they’re basically destroying value.”
OK, you mentioned there are two ways of obtaining funding – but what about “as-a-service?” When does that make more financial sense than raising capital?
“Naturally that depends upon a number of variables. But, fundamentally, when companies are deciding whether to use company capital or as-a-service to fund major projects, the main question should be ‘how will this benefit our overall business needs and goals?’
For example, most companies are always looking for ways to improve their core business. While upgrading facility infrastructure will improve building and system efficiencies, reduce operating costs, and improve working environments for employees, it’s not really core to a company’s business. As such, when companies think about how they’re going to invest their capital, they’re not thinking about facilities or infrastructure upgrades.
Facility upgrades are normally seen as a necessary evil—bottom-line expenses that need to be incurred. And, because of their size, scale, and significance, they generally fit into the capital budgeting process. When using capital, high-cost infrastructure efficiency projects require well-forecasted budget estimates and long, complicated approval processes. Life-span is also a significant factor. Once a company has purchased new systems for their facility, they’re generally committed to stick with them for a long time in order to extend their ROI. Estimating future needs and verifying performance/return-on-investment can be tricky and complicated.
The result? Under normal circumstances, cost-saving facility upgrades have to compete for funding against revenue-producing projects. So, even though companies know the upgrades will save money, if the choice is one project or another, the revenue-producing project wins every time.
But, the company still loses on two counts. First, by failing to upgrade their facilities/improve building efficiencies, they’re paying for energy that their facility is wasting. (Recent Energy Star research reveals that the average commercial building wastes 30% of its energy—year-after-year.) And secondly, they’re not capturing the savings—think positive cash flow—that increased energy efficiencies produce.
The ideal solution would be to do both. That’s where as-a-service works best.
In another situation, a company may not have the capital they need to implement all of the facility energy efficiency upgrades they need. As such, they might compromise the scope of the project or, even worse, settle for less-than-optimum facility upgrades because they’re constrained by the cost of capital or their ROI hurdle/payback threshold.
How can companies use as-a-service to improve upgrade their facilities and systems?
"Energy-as-a-service is a recent entrant to the as-a-service business model, and it is redefining how businesses think about their relationship with energy.
Until now, most companies tended to think of high energy costs as simply the cost of doing business—something beyond their control. Energy-as-a-service is changing that.
Energy-as-a-service provides a truly capital-neutral solution—one that allows companies to avoid the capital expense dilemma—and to implement exactly what they want and need in terms of facility upgrades and energy efficiency. And, of course, the most appealing aspect is that efficiency-as-service allows companies to use their energy savings to pay for all facility upgrades – no upfront capital is required.
Forward-thinking companies are discovering that energy energy-as-a-service allows them to take back control of their energy systems and to align their energy spend with business metrics. Instead of viewing a facility as a drain on capital, energy-as-a-service leverages the company’s real estate as an asset to grow their business.
Efficiency-as-a-service makes sense on a number of levels.
- It reduces complexity, cuts costs, scales quickly
- Provides immediate and on-going positive cash flow
- It allows companies to take advantage of the best and latest energy solutions and technologies
- It shifts the burden of management, implementation, updates, ongoing technology evaluation, and selection to the vendor
- And, ultimately it helps companies run more efficiently and saves them money with no capital expense."
So, in conclusion?
Naturally, there isn’t one solution that is best for every company – or every circumstance. If a company has the capital available, and using it optimize their energy systems and facilities fits into their capital budget plan, that’s the route they should take. But, generally speaking, investing capital back into their core business, and using funding solutions like energy-as-a-service for facility upgrades, delivers the greatest value for companies trying to make the most efficient use of resources and assets.
* iPad launched in 2010. Uber, 2012. Chrome, late December 2008. Airbnb, 2008, Instagram, 2010. Venmo, 2009. GPS on iPhone, 2009. Amazon Echo, 2014.