(Date: 9/98 By: Ian Runge)
Part I – Return on Investment that Reflects Technological Change
Most of our accounting rules and evaluation tools do a poor job of coping with change. Nowhere is this more evident than with assets that last a long time. In your organization how much older equipment do you have that is just sitting around, not worn out, but (truthfully) used once in a blue moon?
This story started at a mine in Wyoming’s Powder River Basin a few years ago, but similar stories probably apply to at least half of the businesses we deal with. The mine had a large shovel being progressively written off over 15 years, but now after only 7½ years (and although it was still on the books at maybe $3 million) it had been parked (stood down) because they had bought an even-larger shovel that was so much more efficient that the older one couldn’t compete. In effect (so they told me) the cost of dirt moved by the new shovel, including repayment of capital, was less than the operating cost of the old shovel. For a typical mining shovel operating costs (excluding depreciation, of course) represent only about 55% of the cost of dirt moved and I didn’t think that in 7½ years we’d had technological advancement to the tune of 45% overall cost reduction.
Usually we assume the world is a relatively constant place (the assumption in most DCF analyses) and we “allocate” (depreciate) acquisition costs over the life of the machine. This allows us to think of production in average or constant cost terms—a “cost” we would have to charge ourselves per unit of production to get an appropriate return on investment over the machine life. Figure 1 shows such a situation.
Figure
1
In this figure the unit cost of production is a constant $0.31/cu.m. over the machine life for a return on investment of 12.5%. The $0.31/cu.m. discounted average cost of production is calculated using depreciation for tax purposes at 15% (declining balance) per year. For book purposes (i.e. the yearly depreciation reported to shareholders, and for asset valuation) depreciation in Fig. 1was assumed straight line over the life of the asset (15 yrs.). Straight line book depreciation yields a return on capital very close to the target return on investment—at least for the first 9 years or so.
Unfortunately the world is not a constant place. The capital cost of new mining machinery including shovels has been coming down at better than 2.5% per year, and when you buy a new shovel it is also more efficient in its use of electricity, maintenance labour and the like. Of course not everything is subject to cost declines—taxes aren’t, for instance. But as real costs decline, some competitor for sure is going to invest in this new equipment and take your market by offering lower prices. Reductions in the fundamental costs of production quickly translate into reductions in selling price—and this applies no less to individual equipment as it does to the output of the enterprise as a whole. In this example I have used a very modest 2.2% annual decline in the fundamental cost of production. 2.2% doesn’t seem very much, but over the 15 year life of the shovel minor changes mount up. Figure 2 shows the same situation as figure 1, but with this 2.2% annual declining price.
Figure
2
After 7½ years the “market” price consistent with new technology has only declined about 15%, so there is still a healthy margin over the operating costs. But the return on capital shows a dramatically different picture. Returns in the order of 6% are only half the planned 12.5% return. Worse still, by year 11 we are still paying tax, yet the return is nil—an artifact of the different depreciation schedules we adopted originally.
What should we do to avoid these problems?
First of all, avoid any myopic focus on cash costs .... cash costs are a survivability guideline and a very poor pointer for choices aimed at ROI.
Secondly, stop making long term investments in the first place without explicitly recognizing that in a competitive marketplace technology will inevitably drive prices lower.
Thirdly, adopt book depreciation schedules that each year correctly reflect the economic value of the future services available from the equipment.
Of course many companies do adjust book values to market, but all-too-often these adjustments rather than being planned are applied as abnormal write-downs.
If it is all too difficult, you can do two things—you can simply ramp up the required hurdle rate before you approve new investments, or you can lean on your own management to get costs down at the rate of 2.2% per year. Let’s look at this approach first—after all, 2.2% per year isn’t much, and that’s what management is paid to do anyway, isn’t it?
Now I agree that management in many industries has comfortably delivered on 2.2% annual cost reduction, through efficiencies and cost reduction in the supply chain and through workforce productivity improvements. But this won’t help the return on capital problem, because the new technology also benefits from these changes! To help the return on capital problem, management must deliver efficiencies in existing equipment that does not apply to the new technology coming along, and which does not require additional capital to bring about! This is a tough call!
What about demanding a higher hurdle rate? If you wanted to pretend (in your cash flow calculations) that the world was a static place, but still make some allowance for the effects of technological advancement, how much should you allow? Most people would be surprised at how much difference this makes. In this example, a 2.2% annual decline in market price translates into about 5% difference in the return! A (supposed) 12.5% return actually yields only 7.25%, or, if you wanted to really achieve 12.5% return you would have to adopt a notional hurdle rate of 17.2%. Much better to do the calculations honestly, in my view!
P.S. Was the company right in replacing their old shovel? On the basis of operating costs for the shovel ..... No! But in this particular case, the shovel replacement decision hinged on the availability of larger trucks that could not be efficiently loaded with the smaller shovel. The choice to replace the shovel was probably the correct one.
Part II - How to value long-life assets subject to technological change
In Part I, I illustrated why, in a competitive market, managers who may nevertheless be superb practitioners in the skill of cost reduction are nevertheless powerless to improve the return on assets.
One word explains all: technology. If a new machine can do the job better than an older machine, then the older machine has to be valued according to this market alternative. When technology is changing fast relative to the physical life of the asset we need more precise rules to value the asset through its life.
There is really no ambiguity in how this should be done—every year, every asset on your books should be put on trial for its life. Ask yourself: If I didn’t own it, would I choose to buy it at the value now on my books? It must compete with whatever else is available, including new and better machines. The value has to reflect the expected future cash flows that the asset is capable of facilitating.
When you purchase the asset you must place a value on it, year-by-year, on the assumption that the cash flows from that year on materialize as you anticipate. This originally anticipated value is the benchmark upon which depreciation should be initially assigned and against which subsequent performance should be measured.
The change in year-to-year value represents the economic depreciation. Unlike depreciation methods based on some physical or time characteristic, or depreciation methods mandated for tax calculations, economic depreciation does not follow any fixed formula.
Figure 3 shows a situation similar to the example in Part I. In this example, the selling price was constant in real terms, not declining. The return on capital calculation considers both straight-line depreciation and economic depreciation.
Figure 3
Straight line depreciation yields a relatively constant return initially, trending upwards for the last one-third of machine life. This trend to higher returns on older assets is often seen and explains the common difficulty in justifying the replacement of older equipment. Depreciation that yields a constant return on assets is actually a U-shaped curve, with higher depreciation at the end. Under this scenario, straight line depreciation still looks pretty good.
Now what happens with a declining selling price due to competition and advancing technology? The cash flow profile that underpins asset valuation is shaped more like a wedge.
Under this scenario what should the depreciation rule be? Straight line methods are out! Figure 4 shows the correct calculation using 2.2% annual decline in revenue.
Figure 4
Under this scenario, the straight line method under-depreciates the asset, and this means profit is overstated in the initial years. In the first 3 years, for example, reported profits exceed real profits by more than 20%.
Figure 5 shows the extent of profit mis-reporting through the life of the machine.
Figure 5
The greater is the rate of technological change, the worse it gets. When market prices decline by 5% annually, even assuming we make allowance for this in the initial investment decision, the straight line method of book depreciation overstates asset values by a staggering 93% at the mid-way point of machine life! Use of economic depreciation becomes even more important.
So what? (I hear you say). If we had a balanced mix of old and new equipment (and it was OK to aggregate assets by class) then nobody should give a hoot. Correct. Where does it matter?
n Growth industries. Expanding businesses have a dis-proportionate mix of newer equipment.
n Where technology is advancing the fastest
n Where assets are valued, reported on, bought, or sold in mid-life.
Does this sound like any situation you know? Technology is advancing everywhere. Even if you are using conservative accounting practices, if you are in a growth business you are susceptible to this problem.
Using economic depreciation demands more than simple application of a formula. Since cash flow is unchanged regardless of how assets are valued internally why go through the extra effort?
} If you get your internal
asset valuation wrong, and you report an unexpected write-down, your share
price will take a hammering. Your cost of capital will go up!
} It makes subsequent change easy! New options (asset rationalisations, disposals) are not hidebound by inappropriate valuations of existing assets that have to be brought to account (but which can remain safely hidden otherwise).
“Change” is the catchcry for efficient management. Economic depreciation ensures your assets aren’t a liability in this change process!
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