Business Tools Blog

A question from Chris Murphy:

Could you please explain the financial formulas used to determine whether a capital project should be approved?

I love this question.  It shows that our sales team understands when spending capital is appropriate.  Cash flow is our most important metric.  Growing revenue is also important, but only in the context of growing cash flow.

Chris is asking about SBC (Success Based Capital) and Zayo is fortunate to be in a position to fund organic network growth.  In other words, we can meet customer’s needs by making investments in our network.  But how do we know which investments are good and which capital projects should fall on the cutting room floor?

The analysis that you typically think about when evaluating projects is NPV (Net Present Value).  If NPV is >0 then a project should be approved.  The problem with NPV is that it assumes unlimited investment capital and doesn’t easily factor risk of payback or opportunity for additional business based on a project.

Definition: NPV is the present value of the future cash flows minus the initial investment.   NPV is a straightforward formula in excel - explained in Microsoft Office.

Another way to look at SBC is “Capital Intensity Ratio”.  In Telecom, Capital Intensity Ratio is calculated as SBC/Gross Installs (For every dollar of Gross Installs, your company expects $X of SBC).  This ratio is also a loose approximation of cash on cash payback.  Example, if you spent $2 for every $1 of Monthly Gross Installs, your Capital Intensity Ration would be 2.0 and your payback would be 2 months.

A company that is growing their network will have a higher capital intensity ratio.  The appropriate Capital Intensity Ratio is determined by the Board of Directors.  The Capital Approval Process should evaluate projects based on maintaining the approved SBC ratio, growing revenue, and strategically expanding the network.  To compare:

1. Project 1 has a capital intensity ratio of 3.0 to a single tenant building in a single tenant office park.
2. Project 2 has a capital intensity ratio of 5.0 to a large multi-tenant building along a route with other large multi-tenant buildings.

Project 2 is likely the better project and more likely to be approved because the capital dollars have potential to serve a larger base of customers.

Other factors that are considered:

• Contract Term
• Customer’s financial strength and potential growth
• Competition
• Size of the project