Time is Money
Project stalled? Apply the opportunity test.
By Alan Whitson, RPA
Do you enjoy missing an opportunity to save your company money? Of course not, but companies all around the world let millions of dollars slip through their fingers every day. Why? They either ignore or fail to understand the time value of money and its impact on their facilities.
Rule one regarding the time value of money is straightforward: “More is better than less.” Who wouldn’t want $200 rather than $100? It’s the second rule, “Sooner is better than later,” where the understanding can get fuzzy. Given the choice between getting $100 on January 1 or waiting until the end of December to receive the money, which is better? Take it January 1, because you could invest the $100 for a year and earn interest. By waiting until December, you give up the opportunity to earn that interest. The financial buzzword for this concept is “opportunity costs.”
Where it gets fuzzy is when you have choices like these:
A. Getting $100 on January 1 and investing it at 5.75 percent per year.
B. Waiting until December 31 and receiving $120.
C. Getting $100 on January 1 and loaning it to your brother-in-law who promises to pay you back in December with interest.
Some quick arithmetic leads one to select “B,” even though in “A” it’s clear that receiving $100 on January 1 is “sooner” than December 31. However, getting $120 on December 31 is “more” than $105.75 — the $100 plus the $5.75 of interest earned during the year. Alternatively, it would take 3.26 years for “A” to grow to $120. However, if the $120 in option “B” could be reinvested at the 5.75 percent per year in option “A,” it would have grown to $136.16 during the same time period as it took option “A” to grow to $120.
In short, option “B” will earn more money sooner that option “A.” That’s what the time value of money is all about — knowing which opportunity creates the maximum value over a given time period.
Frequently, facilities professionals talk about projects designed to reduce costs being delayed due to concerns about the “capital budget process.” As the story unfolds, it appears you’re listening to dialogue from Alice in Wonderland: “We can’t afford to save money. There is nothing in the budget for it. You’ll need to put this project in next year’s budget.”
When given an opportunity to save money – just do it! “There is nothing in the budget for it” is inside-the-box thinking. Many facility projects can be funded outside of a company’s traditional capital budget process. Energy-efficiency projects, for example, provide a quick and predictable positive cash flow from lower energy bills, allowing them to be funded through performance contracts or off-balance sheet leases. Items that reduce churn costs, such as modular walls, raised floors, structured cabling systems, and carpet tile, can also be leased. Leasing offers the ability to change a lump sum capital expenditure into a series of operating lease payments.
Let’s examine a real life project that would reduce operating costs and analyze the impact of delaying the project until next year’s capital budget cycle. (See Impact of Project Delay, page 11-BI.)
Whether the project is done this year or next, the annual savings don’t change. They’re still $360,000 a year. Over a five-year period the cumulative savings would be $1.8 million. However, delaying the project one year would reduce the five-year savings to $1.44 million (the $360,00 not saved during the one-year delay. What the analysis in this table is missing is the consideration for the “opportunity cost.”
Companies don’t sit on their cash; they invest it in many ways until the business requires that cash. Even then, when investing in the core business, that cash must earn a minimum rate of return — often called the “hurdle rate.” Many corporations use a “hurdle rate” of from 18 to 20 percent.
For this analysis, use 20 percent as the investment rate for our annual savings. Reinvesting the $360,000 in annual savings at 20 percent per year for five years, the cumulative savings grows to more than $3.1 million. However, delaying the project’s implementation one year reduces the project five-year savings by $887,651 — almost the same as the initial cost of the project!
Of course, by delaying the project one year the company could earn interest on the $900,000 that the project cost. Using the one-year treasury rate (5.75 percent) would be appropriate considering the issues of timing and risk.The interest earned on the $900,000 would be $51,750; even at 20 percent, the interest earned would only be $180,000 — half the annual savings. Clearly, it’s in the company’s best interest to do this project now.
Every day, opportunities arise to reduce costs. The sooner one starts to save, the more one saves, and the greater the opportunity to reinvest the savings. As the adage goes, “Time is money.”
Alan Whitson, RPA is CEO of B. Alan Whitson Co., Newport Beach, CA.