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Module 12: Capital Investment Analysis – Part I

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Content

Mod 12: For Your Success

Learning Outcomes

1. Describe the relation of capital investment analysis to the management process.

2. Calculate capital investment evaluations including using net present value.

Mod 12: Readings

Required

o Chapter 10 in Managerial Accounting

Mod 12: Content

I. Planning for Capital Investments

When a companys executive management decides to spend substantial resources for expansion or to replace outdated equipment, it is essential that quantitative measurements be calculated to ensure that the outlay of resources will align with the organizations long term strategic plan and increase shareholder wealth in the long run.

Key Motives for Making Capital Expenditures

Motive

Description

Expansion

The most common motive for a capital expenditure is to expand the level of operations usually through acquisition of fixed assets. A growing firm often needs to acquire new fixed assets rapidly, as in the purchase of new property and plant facilities.

Replacement or renewal

As a firm’s growth slows and it reaches maturity, most capital expenditures will be made to increase efficiency by replacing or renewing obsolete or worn-out assets. Renewal may involve rebuilding, overhauling, or retrofitting an existing fixed asset. Each time a machine requires a major repair, the outlay for the repair should be compared to the outlay to replace the machine and the benefits of replacement.

Other purposes

Some capital expenditures do not result in the acquisition or transformation of tangible fixed assets. Instead, they involve a long-term commitment of funds in expectation of a future return. These expenditures include outlays for advertising campaigns, research and development, management consulting, and new products.

The first step in planning for capital investments involves identifying the companys capital investment needs. An increase in demand for a product can motivate a company to expand the manufacturing facilitys capacity. A launch of a major new product can motivate a company to invest in a very large advertising campaign. The aging of the truck fleet may motivate the company to purchase a new truck fleet. All of these capital investment projects can be supported qualitatively, but they must also meet the quantitative requirements to move to the next stage of planning, the acceptance or rejection stage.

Companies establish the acceptance or rejection criteria as a part of the long term strategic plan. The most important criteria than any capital investment project must hurdle is the ability to maintain or increase shareholder wealth. If the project will cost the company resources in the long term, rather than maintain or create wealth, then it is automatically rejected. The companys cost of capital is often used as the benchmark for accepting and rejecting projects. We will discuss the cost of capital below.

Once a project meets the companys acceptance as profitable, it must be evaluated against all projects that have met the acceptance standard. Evaluation of acceptable projects is the quantitative process of determining the profitability and wealth enhancement of each project. We will learn to apply two different models below. But first, we must go over some basic finance before we delve into capital budgeting techniques.

II. Cost of Capital and the Time Value of Money

As we evaluate capital budgeting projects, we use a figure called the cost of capital as our discount rate, or the rate at which the project must earn a return on its investment. In essence, the cost of capital is the rate of return that a firm must earn on the projects in which it invests in order to maintain its wealth or the market value of its stock. The cost of capital is an extremely important financial concept as it is the link between the firms long-term investment decisions and the shareholders wealth. It truly is the magic number that is used to decide whether a proposed investment will increase or decrease the companys stock price.

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One of the components to the cost of capital is the companys capital structure. Capital structure is the firms mix between long- term debt and equity sources of funds. In the figure to the right, the right side of the balance sheet is shown. This is where the capital components are found on the financial statements and where we will find the figures to calculate cost of capital and capital structure.

Lets look at each of these components in the long term debt and equity sections of the balance sheet starting with long term debt. Common sense might have you assume that a company would not desire to have debt. But actually, debt is the least expensive form of capital. The reason that debt is considered desirable is because the interest cost associated with debt is tax deductible. Therefore, the interest cost lowers a companys net income and in turn, lowers its taxes. The disadvantage to debt is where your common sense is correct. At a certain level of debt, a company is carrying too much debt in its capital structure and the risk associated with high fixed interest costs would become greater than the desirable tax deduction associated with the interest payments.

Our next form of capital for which we will consider the cost is preferred stock. Recall that preferred stock is a hybrid form of equity capital in that the dividends are fixed payments similar to interest payments for the company. The difference is the company does not pay the principle or original investment back to the stockholder unless the company calls the preferred stock. The cost of preferred stock is almost always higher than the cost of long term debt.

Our next capital component on our balance sheet is common stock equity. The cost of common stock is usually slightly higher than the cost of preferred stock.

Our final form of equity for which we must provide the cost is retained earnings. The cost of retained earnings is usually similar to the cost of common stock, but sometimes differs depending on the health of the company. Calculating the individual costs of the sources of long term funds is beyond the scope of this course, but is covered in finance courses. We will look at an example here where the individual costs of funding sources are given, but we must calculate the cost of capital.

Assume that all of our forms of capital have a cost as shown below.

Long Term Debt 5.6%

Preferred stock 10.6%

Common Stock and Retained Earnings 13%

Lets assign dollar amounts to these capital components in order to calculate the weights of each component:

Capital Component

Amount

% of total

Cost assumed above

Cost multiplied by weight (% of total X Cost)

Long Term Debt

$400,000

40% ($400,000 / $1,000,000)

5.6%

(40% x 5.6%) = 2.2%

Preferred Stock

$100,000

10% ($100,000 / $1,000,000)

10.6%

(10% x 10.6%) = 1.1%

Common Stock and Retained Earnings

$500,000

50% ($500,000 / $1,000,000)

13%

(50% x 13%) = 6.5%

TOTAL DEBT AND EQUITY FUNDING SOURCES

$1,000,000

100%

(2.2% + 1.1% + 6.5%) = 9.8%

By multiplying the percentage of the capital component by the cost of that component, we find the weighted cost of that component. We then add all of the weighted costs together to find the cost of capital. In this example, our cost of capital is 9.8%, so any projects that the company invested in would have to earn at least a 9.8% return, or the shareholders wealth would be eroded.

VIDEO

WST: 3.4 Finance 101 – WACC Defined and Calculated

Length – 05:22

Source: http://www.youtube.com/watch?v=PJHLLU76PRs

The Time Value of Money

You are probably familiar with the concept of interest which is the cost of money. Recall that the calculation for simple interest is the principal amount times the interest rate times the time or duration of the investment (principal x rate x time). If you have a savings account, the interest you earn is probably compounded. That means the interest when earned is added to the principle to calculate the next period of interest.

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We knew how much Andy was investing today ($5,000) and we knew what rate of interest (6%) he would earn. What if we know the amount of money that we need at a future date and we know the rate of interest we can earn, but we need to know how much to invest today? We would use present value.

In the example to the left, Daschel Company knows that they will need $1,000 in 1 year. They also know that they can earn 5% interest over the year. They need to know how much money to deposit today so that they will have $1,000 in one year.

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Daschel Company needs to deposit $952.38 today in order to have $1,000 in one year.

In the previous example, we assumed that there was only one initial deposit and one withdrawal. What if payments were made over specific intervals to achieve our goals? If more than one payment is involved, it is called a stream or an annuity. An annuity can be calculated to occur at the end of a period, which is called an annuity due, or at the beginning of the period which is called an ordinary annuity.

Lets try an annuity type problem now using a spreadsheet. Assume that Fran can deposit $1000 into her savings account every year for five years. She can either start depositing her annual $1000 today (annuity due column B below), or she could wait and deposit the first $1000 at the end of the year (ordinary annuity column A below).

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Assume Fran chooses to wait and deposit her first $1000 at the end of the year, column A ordinary annuity. Using a spreadsheet, lets calculate how much she will have in five years.

A

B

1

FUTURE VALUE OF AN ORDINARY ANNUITY

2

Annual payment

$1,000

3

Annual rate of interest, compounded annually

7%

4

Number of years

5

5

Future value of an ordinary annuity

$5,750.74

Entry in Cell B5 is =FV(B3,B4B2)

The minus sign appears before B2 because

the annual payment is cash outflow.

End of year

Payment amount

1

2

3

4

5

$11,500

$14,000

$12,900

$16,000

$18,000

When the payments in an annuity are not the same amount every period it is called a mixed stream. Lets work a problem to illustrate using the spreadsheet for a mixed stream of payments. Assume that Shrell Industries has a customer that will be paying his bill over the next five years. The customer has agreed to a payment schedule that corresponds favorable with its own cash availability. The agreed upon payment structure is shown to the right.

Shrell Industries plans to invest these payments and expects to earn 8% over the 5 years. Shrell Industries wants to know how much money will be in their investment account at the end of five years. (note that without any interest considered, the total of the five payments is $72,400)

A

B

1

FUTURE VALUE OF A MIXED STREAM

2

Interest Rate, %/year

8%

3

Year

Year-End Cash Flow

4

1

$11,500

5

2

$14,000

6

3

$12,900

7

4

$16,000

8

5

$18,000

9

Future value

$83,608.15

Entry in Cell B9 is =FV(B2,A8,0,NPV(B2,B43:B8)).

The minus sign appears before FV to convert the future value to a positive amount.

Since Shrell Industries invests the payments from their customer at 8%, they will have $83,608.15 in their investment account at the end of five years.

Our text has more examples and problems you can work on spreadsheets. You can practice these problems on your own following the instructions for inputting the formulas. You may even find some of these calculations useful for your personal finances.

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