to generate future cash flows from another product line or service. Similarly, if NetInvest is negative, it could signify that once again there is no need to replace all existing assets at the rate they are being depreciated. It could simply be that the investments being made are for a new product line or service but the investment is less than the depreciation of assets on the books. Finally, if NetInvest is positive, it could signify that existing assets are being replaced with assets that have more capacity or the assets aren't being replaced at all but rather the investments are in a new product line or service or investments are being made at an accelerated pace for a period of time.
The point is: The term NetInvest only indicates the magnitude of investments being made relative to the depreciation and amortization that is taking place. It also quantifies the net magnitude of expenditures that will have an impact on Net Income and Cash Flow for many periods. In and by itself, it doesn't say anything about the kind of investments that management have chosen to make.
For this reason there is also a need to focus and understand investments that are being made and not reflected in the definition of Investments (capitalized investments) but can have an impact on Revenue, Net Income, and Cash Flow.
Investments that are typically capitalized and depreciated over time are:
• New plant and equipment: Maintenance can perhaps extend equipment life indefinitely. However, at some point it becomes inefficient. In addition, equipment manufacturers are continuously improving their product. This results in the next generation being able to perform better, cheaper, and faster. Equipment is purchased for various reasons. Whether it represents a replacement for a worn-out machine or new technology, it is an investment.
• New or upgraded software: While there aren't any technical reasons why software can't last forever, developers continue to develop more powerful releases and new applications. This results in decisions to discontinue factory support for older versions. Upgrading isn't a trivial project. Systems that control the enterprise or parts thereof are very sophisticated and any change involves risk. To offset this risk considerable planning takes place, which results in detailed implementation plans that can turn upgrades into a major investment.
• Acquisitions: Growth strategies are often based on acquiring cash flow, products, technologies, companies, and so on, which involve goodwill, non-competes, patents, and so on, all of which represent an investment.
Expenditures that are not capitalized because the expected result is too difficult to quantify over time are:
• Research and development: In most companies it's mostly “D” with little “R” and when R does exist it is usually “r.” In well-run organizations the R&D budget represents an investment in products, services, and cost reduction.34
• Quality control program: This is an investment in cost reduction, risk management, and happy customers.
• Productivity program: Companies cannot count on price increases to offset cost increases. To maintain or improve gross margin, a company has to continuously invest in improving its productivity.
• Marketing: Depending on the organization this can be large “M” or small “m.” Be that as it may, marketing represents an investment in placing the company's product or service top of mind with consumers.
• Sales: This may not traditionally be considered an investment, but it is one nevertheless. Whether the contact is in person, by telephone, or via the Internet, the objective is always to get an order for a product or service at an attractive price from either new or repeat customers in existing or new markets. This doesn't just happen. To capture the customers' wallet takes an investment in time and money.
• Administration: Investments are made all the time in this area in both people and systems. The objective is to provide efficient infrastructure and services to the various operating entities. To do so, a company must continually strive to be best in class and this takes resources that require investments.35
• Lawyers: While not always viewed as such, the legal profession has a role to play, and experience has shown that it pays to invest in legal advice up front as opposed to fighting it out in court.36
• Accountants: This is an investment by the owners of the business in getting an independent assessment of the company's financial condition, and for public companies is a legal requirement. In addition, management will often call on accountants for specialized advice on such things as improving the control environment and minimizing taxes. Both of these represent value to the business. The first reduces risk by providing advice on best practices. The second results in more after-tax cash flow.37
• Investment bankers: Companies frequently require capital and such services as strategic advice. Bankers provide these (and other) services for a fee, which can represent an investment in improving the capital structure of the company and/or maximizing shareholder value by considering various strategic alternatives.38
The list goes on. The point is: Investments are not merely expenditures that offset depreciation or amortizing assets. Investments, in the context of this discussion, include select items in several categories.39
[2-6]Investments = Property + Plant + Equipment + Software + Acquisitions + Intangibles + Operating Investments
So, in summary, Investments are not merely the difference between the D&A of existing assets and expenditure on like kinds of assets. They include those just discussed and much more. However, to simplify the discussion, the investments discussed in the context of Net Investments refer to investments that are capitalized, such as facilities, equipment, and software.
Since Investments are what ultimately drive growth and cash flow, the rate at which they are made is of interest. For example, if a project that involves $1,000,000 of investment is completed in three years, its impact on the company's growth will be different than if it was completed in two years, all other things being equal. Hence, the rate at which a company invests money or the “Investment Rate” is a concept that needs to be explored.
⧉ Investment Rate
There is a strong correlation between investments and Net Income in most companies. Therefore, rather than think of Net Investments as an absolute number, it is often more convenient to think of it as a percentage of net income, especially when preparing pro-forma financial statements for business plans, preparing cash flow streams for present value analysis, and so forth.
This is done by defining the Investment Rate IR in Year n as the ratio of NetInvestn in Year n to Net Income NIn in Year n (Equation [2-7]).
[2-7]
Rearranging, Equation [2-7] becomes:
[2-8]NetInvestn = (NIn)(IRn)
Equation [2-8] is the First Envelope Equation. It is the cornerstone of the Net Investment Version of the Envelope Equations because it defines Net Investment in terms of Net Income and the Investment Rate and will surface many times in the following sections.
Special Case: Constant Investment Rate
Equation [2-7] is a solid definition for the Investment Rate under all circumstances. As will be seen, its more useful form is Equation [2-8].40 However, in many companies the Investment Rate doesn't change much from one year to the next and, therefore, in numerous situations or as a first approximation the IR can be viewed as a constant. Dropping the subscript on IR accomplishes this. Hence, under these conditions Equation [2-8] becomes
[2-9]NetInvestn = (NIn)(IR)
⧉