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Principles of finance, a la shmoop. Capital efficiency trade-offs: where and

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how do I spend my cash? All right well let's take a look at a gnarly tractor

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smelting example case study today you stamp out about ten tractors a week in [Man presenting]

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Bessie your 38 year old factory and plant

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she's stalwart wide hip and sturdy she did you proud and well now she's falling

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apart it's a miracle she lasted this long

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she was only warrantied for 20 years so 38 is like 2x and you've already

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depreciated away all of her costs so your tractor company appears to be very

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profitable from an earnings basis in fact it looks like this contribution

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margin is how much profit the unit generates for its n plus 1 unit in this [Contribution margin definition appears]

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case that $50,000 tractor sells that retail to dealers for 80 grand

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and yes the factory then you'd say whole sales it to those dealers for 50 grand

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alright well the cost of the metal assembly electronics treads engine and

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so on is 40 grand so the extra n plus oneth tractor generates $10,000 in

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contributed profits well the company's summary income statement for last year [Income statement appears]

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looks like this so this is a nice little company great tractors independent

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Heartland America but weirdly there's nothing in the DNA line like if the

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company had bought a plant some years ago shouldn't there be a plug to

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depreciate it well yes but their CFO didn't take this

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course had she she would have put in a line

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called sinking fund or something similar so it was budgeted on the line such that [Wood burning in the fire]

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when old Bessie finally died and was resting comfortably stuffed by the

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tractor dermist sitting by the fireplace she'd have a replacement the

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company shows kind of "false" profits here right if a new

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basic plan cost twenty million dollars and Bessie is fully depreciated 20 years

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ago well for the last 18 years we probably should have been socking away a [People working in a factory]

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few nuts to fund the build of a new plant and we should have deducted a bit

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more than a million bucks a year to fund that it would have come right off our

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taxes but we didn't do that we took the excess free cash and stupidly

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distributed as dividends to the laborer owners why did we do that well they wanted to [Man carrying sacks of cash]

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get paid understandably unfortunately in the process they robbed the company of

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cash resources to build a new plant now that this one was well pretty much done [Explosion occurs]

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how could this have happened well the people in charge of dividend

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distribution were the highly tenured laborers those who had been at the plant

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over 25 years they were a year or two from retirement by the time Bessie was

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going to die so why would they worry about long-term planning take the money

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and run right well that's why you have diversified boards and it's a big issue

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when it comes to capital expenditures if you don't have a range of voices [Men discussing matters in a meeting]

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speaking up for those who will be at the company 20 years later while you end up

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anemic at best luckily despite the short-sighted financial management of

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capital tread on me has had a great reputation as a builder of high-end

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tractors and banks are happy to have the conversation about giving them a loan

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for a new factory well the basic new one will cost 20 mil but allow the company

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to make the same 300 tractors now for 30 thousand bucks each instead of 40

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thousand there that they've been making them for before and guess what the new

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factory replaces one-third of the laborers with robots [Factory robot machine working]

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surprise surprise maybe that's why the old guys took the money and ran instead

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of spending the plant capital on robots and while the new plant is just

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generally more efficient with inventory assembly tracking metrics and so on so

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on this new plant factory will hold all of the other variables to be the same

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and instead of making 10 grand a unit of 300 in a year 300 produced in a year

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they'll make 20,000 in pre-tax profit or contribution per unit that's double so [Pre-tax profit highlighted]

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pre-tax profit is going to be 6 million bucks give or take remember that times

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interest covered ratio thing we covered before well shoot were 3x and change

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here the factory is 20 million dollars divided operating income of 6 million

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and you get to 20 over 6 about 3.3 X well it's pretty easy and easy to get to [Person holding Basic factory build folder]

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a YES on the basic factory build in 3 years and change the factory is fully

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paid off the conservative founder of tread on me would rest easy

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but the young whippersnappers angry about how the old guys left them are

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more greedy than fearful they haven't lived

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through many bad economies and they seek risk they're ready to do the fancy [Robots working on tractors]

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factory which will let them stamp out more tractors with more bells and

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whistles albeit in an unproven marketplace which may or may not want

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them fancy right all right well they can count on for now the same numbers is the

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basic factory sales going forward right so the question then is how much could

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we spend on a new factory and still sleep at night well the answer revolves

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around the cost of money and the time required for them to pay back that loan

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if they had to pay everything back in four years well they couldn't afford

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much more than what they're spending in this 20 million dollar version of

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capital for a basic factory in theory after year three if they had paid back

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and say fifteen million dollars in owed just five million at that point well [Interest graphs appear]

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they could refinance and extend the payback terms if they had to but let's

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say the board is worried about a global economic meltdown or the new Google

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driverless tractor so they want read my lips no debt in four years just like the

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bank does well the money costs five percent and it is secured by the entire

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business that is if the company doesn't pay back the loan the company is owned

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by the bank who loaned them the money and the bank is betting that the entire [Man put down gambling chips on roulette table]

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company will be worth more than what they're loaning them the money for so

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let's say the super duper factory is forty million dollars to build well the

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company has six million in operating profits they have to pay back loan in 20

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years so they owe two million in principle each year and they'll pay in

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year one five percent of forty million borrowed or two million in interest the

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interest is deductible the principle is not so together these two elements

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comprise four million dollars in cash costs to the company each year doable

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yes they have six million in profits here plenty of cushion and you can do

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the math that two million dollars goes against taxes so instead of paying a

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third of their operating profits of six million dollars in taxes or two million

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dollars in taxes if taxable income now of six million minus the two million of

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interest costs or taxable income of four million bucks and then a third of that

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is 1.3 million note that is the principle owed declines ie 40 million [Principle owed declining on a graph]

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owed in year one and 38 million million in year two and so on the

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interest cost on that money declines as well by year ten tread on me owes twenty

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million dollars on SuperDuper at five percent or just a million bucks a year

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in interest half of what they started with but as always here at shmoop [Man holding baseball bat]

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central there's a curve ball the economy tanks Google cranks and the next year

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instead of selling three hundred tractors like they had for decades they

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only sell two hundred so the board is thinking woe is me why did we ever

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upgrade Bessie? well for four million dollars we could have fixed her up and

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gone producing three hundred tractors a year for another ten years

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well that math is totally different of course with almost no needs for capital [Wheel of fortune wheel appears and lands on taxes]

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expenditures company finds itself with tons of options and tons of taxes tread

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on me left with bessie continues for a decade or more with $10,000 per tractor

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in pre-tax profit or three million of pre-tax profit and cash builds up ensure

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the company pay a big dividend well only equity holders get dividends and

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only a relative handful of labor owners maybe 10% own equity shares in the

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company the rest just get paid a salary a small bonus if quotas are met and a

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free turkey for christmas well they feel unfairly treated if the company just

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hoards its cash and oh by the way the company just got to tax 33 [Man points to taxes in presentation]

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percent on its profits if it pays a dividend the employees get taxed a

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second time on that dividend fair? doesn't matter it's how the laws are set

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up what else can the company do beyond upping the dividend well it could just

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keep the cash pouring but good rainy day fodder does the board trust that

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management won't spend it stupidly maybe the company could also use the excess [Men sitting in board room]

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cash to buy back its own stock fewer shareholders out there mean the same

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volume of cherry pie is shared with fewer mouths so each eater gets more but

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then the capital that probably should someday be used for a new factory has

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been given over to equity owners who are basically leaving the business that is

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when they sell out their equity stakes and move on they no longer financially [Woman running away from exploding building]

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care whether the business is doing well or not it's likely that some were at

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least partly responsible for the 300 tractors that got sold every year so

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what happens now that those workers are gone? Does the Department of

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Agriculture still buy five tractors a year or do those sales just go away to a

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competitor now hopefully you get the idea here lots of moving [Man discussing companies]

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parts lots of choices with what you do with your free cash as a company and

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factories matter the spiffy new ones don't need humans though so you know

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here's hoping you and the robots get along [Robot working in factory]

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