Prentice Hall's one-day MBA in finance & accounting (29 page)

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A company’s cost of capital depends on its capital structure.

Assume the following facts for a business:

Capital Structure and Cost of Capital Factors

• 35 percent debt and 65 percent equity mix of capital sources

• 8.0 percent annual interest rate on debt

• 40 percent income tax rate (combined federal and state)

• 18.0 percent annual ROE objective

These assumptions are realistic for a broad range of businesses, but not for every business, of course. Some businesses use less than 35 percent debt capital and some more. Over time, interest rates fluctuate for all businesses. Furthermore, one could argue that an 18.0 percent ROE objective is too ambitious. The 40 percent combined federal and state income tax rate is based on the present rate for the federal taxable income brackets for midsized businesses plus a typical state income tax rate. In any case, the cost-of-capital factors can be easily adapted to fit the circumstances of a particular business once an investment spreadsheet model has been prepared.

Suppose the business with this capital structure has $10

million capital invested in its assets. What amount of annual earnings before interest and income tax (EBIT) should the business make? This question strikes at the core idea of the cost of capital—the minimum amount of operating profit needed to pay interest on its debt, to pay its income tax, and to produce residual net income that achieves the ROE goal of the business.

Figure 14.1 shows the answer to this question. Given its debt-to-equity ratio, the company’s $10 million capital comes from $3.5 million debt and $6.5 million equity—see the condensed balance sheet in Figure 14.1. The annual interest cost of its debt is $280,000 ($3.5 million debt × 8.0% interest rate

= $280,000 interest). The business needs to make $280,000

operating profit (or earnings before interest and income tax) to pay this amount of interest.

Interest is deductible for income tax, as you probably know.

This means that a business needs to make operating profit equal to but no more than, its interest to pay its interest. In other words, the $280,000 of operating profit is offset with an
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Condensed Balance Sheet

Condensed Income Statement

Assets less

Earnings before interest

operating liabilities

$10,000,000

and income tax (EBIT) $2,230,000

Interest

($ 280,000)

Sources of Capital

Taxable income

$1,950,000

Debt

$ 3,500,000

Income tax

($ 780,000)

Equity

$ 6,500,000

Net income

$1,170,000

Total

$10,000,000

FIGURE 14.1
Operating profit (EBIT) needed based on capital structure of
the business.

equal amount of interest deduction, so the business’s taxable income is zero on this layer of operating profit.

The cost of equity capital is a much different matter. On its $6.5 million equity capital, the business needs to earn $1,170,000 net income ($6.5 million equity × 18.0% ROE =

$1,170,000 net income). To earn $1,170,000 net income after income tax, the business needs to earn $1,950,000 operating earnings before income tax ($1,170,000 net income goal ÷ 0.6

= $1,950,000). The 0.6 is the after-tax keep; for every $1.00 of taxable income the company keeps only 60¢ because the income tax rate is 40 percent, or 40¢ on the dollar. On TEAMFLY

$1,950,000 earnings after interest and before income tax, the applicable income tax is $780,000 at the 40 percent income tax rate, which leaves $1,170,000 net income after tax.

Take note of one key difference between the net income needed to be earned on equity versus the interest needed to be earned on debt. From each $1.00 of operating profit (earnings before interest and income tax, or EBIT) a business can pay $1.00 of interest to its debt sources of capital. But from each $1.00 of operating profit a business makes only 60¢ net income for its equity owners after deducting the 40¢ income tax on the dollar. Put another way, on a before-tax basis a business needs to earn just $1.00 of operating profit to cover $1.00 of interest expense. But it needs to earn $1.67

(rounded) to end up with $1.00 net income because income tax takes 67¢.

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In summary, based on its capital structure, the business should aim to earn at least $2,230,000 operating profit, or EBIT, for the year. If it falls short of this benchmark, its residual net income for the year will fall below its 18.0 percent annual ROE goal. If it does better, its ROE will be more than 18.0 percent, which should help increase the value of the equity shares of the business.

SHORT-TERM AND LONG-TERM

ASSET INVESTMENTS

Looking down the asset side of a business’s balance sheet, you find a mix of short-term and long-term asset investments. One major short-term asset investment is inventories. The inventories asset represents the cost of products held for sale. These products will be sold during the coming two or three months, perhaps even sooner. Another important short-term investment is accounts receivable. Accounts receivable will be collected within a month or so. These two short-term investments turn over relatively quickly. The capital invested in inventories and accounts receivable is recovered in a short period of time.

The capital is then reinvested in the assets in order to continue in business. The cycle of capital investment, capital recovery, and capital reinvestment is repeated several times during the year.

In contrast, a business makes long-term investments in many different operating assets—land and buildings, machinery and equipment, furniture, fixtures, tools, computers, vehicles, and so on. A business also may make long-term investments in intangible assets—patents and copyrights, customer lists, computer software, established brand names and trademarks developed by other companies, and so on. The capital invested in long-term business operating assets is gradually recovered and converted back into cash over three to five years (or longer for buildings and heavy machinery and equipment).

The annual sales revenue of a business includes a component to recover the cost of using its long-term operating assets. (Of course, sales revenue also has to recover the cost of the goods sold and other operating costs to make a profit for the period.) The cost of using long-term assets is recorded as depreciation expense each year. Depreciation expense is not a cash outlay—in fact, just the opposite.

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Depreciation is one of the costs embedded in sales revenue; therefore the cash inflow from sales includes a component that reimburses the business for the use of its fixed assets during the year. A sliver of the cash inflow from the annual sales revenue of a business provides recovery of part of the total capital invested in its long-term operating assets. What to do with this cash inflow is one of the most important decisions facing a business.

To continue as a going concern, a business has to purchase or construct new long-term operating assets to replace the old ones that have reached the end of their useful economic lives.

In deciding whether to make capital investments in long-term operating assets, managers should determine whether the new assets are really needed, of course, and how they will be used in the operations of the business. They should look at how the new assets blend into the present mix of operating assets. Managers should focus primarily on how well all assets work together to achieve the financial goals of the business. These long-term capital investments of a business are just one part, though an important part to be sure, of a business’s overall profit strategy and planning.

THE WHOLE BUSINESS VERSUS SINGULAR

CAPITAL INVESTMENTS

From the cost-of-capital viewpoint, the key criterion for guilding investment decisions for the replacement and expansion of long-term assets is whether the business will be able to maintain and improve its return on assets (ROA) performance.

Suppose a business has been able to earn an annual 20 percent ROA consistently over several years. In other words, its annual EBIT divided by the total capital invested in its assets has hovered around 20 percent for the past several years.

And assume that the business does not plan any significant change in its capital structure in the foreseeable future.

Assume that this level of financial performance is judged to be acceptable by both management and the shareowners of the business. Therefore, in making decisions on capital expenditures to carry on and to grow the business, its managers should apply a 20 percent cost of capital test: Will EBIT in future years be sufficient to maintain its 20 percent ROA per-

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formance? This is the key question from the cost-of-capital point of view.

ROA is an investment performance measure for the business as a whole. The entire business is the focus of the analysis. Its entire assemblage of assets is treated as one investment portfolio. Its earnings before interest and income tax (EBIT) for the year is divided by this amount of capital to determine the overall ROA performance of the business.

In contrast, specific capital investments can be isolated and analyzed as singular projects, each like a tub standing on its own feet. Each individual asset investment opportunity is analyzed on its own merits. One important criterion is whether the investment passes muster from the cost-of-capital point of view.

CAPITAL INVESTMENT EXAMPLE

Suppose that a retailer is considering buying new, state-of-the-art electronic cash registers. These registers read bar-coded information on the products it sells. The registers would be connected with the company’s computers to track information on sales and inventory stock quantities. The main purpose of switching to these cash registers is to avoid marking sales prices on products. Virtually all the products sold by the retailer are already bar-coded by the manufacturers of the products. The retailer would avoid the labor cost of marking initial sales prices and sales price changes on its products, which takes many hours. The new cash registers would provide better control over sales prices, which is another important advantage. Some of the company’s cashiers frequently punch in wrong prices in error; worse, some cashiers intentionally enter lower-than-marked prices for their friends and relatives coming through the checkout line.

Investing in the new cash registers would generate labor cost savings in the future. The company’s future annual cash outlays for wages and fringe benefits would decrease if the new cash registers were used. Avoiding a cash outlay is as good as a cash inflow; both increase the cash balance. The cost of the new cash registers—net of the trade-in allowance on its old cash registers and including the cost of installing the
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new cash registers—would be $500,000, which would be paid immediately.

The company would tap its general cash reserve to invest in the new cash registers. The retailer would not use direct financing for this investment, such as asking the vendor to lend the company a large part of the purchase price. The retailer would not arrange for a third-party loan or seek a lease-purchase arrangement to acquire the cash registers. As the old expression says, the business would pay “cash on the barrelhead” for the purchase of the cash registers.

The manager in charge of making the decision

decides to adopt a
five-year planning horizon
for this capital investment. In other words, the manager limits the recognition of cost savings to five years, even though there may be benefits beyond five years. Labor-hour savings and wage rates are difficult to forecast beyond five years, and other factors can change as well. At the end of five years the cash registers are assumed to have no residual value, which is very conservative.

The future labor cost savings depend mainly on how many work hours the new cash registers would save. Of course, estimating the annual labor cost savings is no easy matter.

Instead of focusing on the precise forecasting of future labor cost savings, the manager takes a different approach. The manager asks how much annual labor cost savings would have to be to justify the investment.

For example, would future labor cost savings of $160,000

per year for five years be enough? The labor cost savings would occur throughout the year. For convenience of analysis, however, assume that the cost savings occur at each year-end.

The company’s cash balance would be this much higher at each year-end due to the labor cost savings.

The retailer’s capital structure is that presented in the earlier example. As shown in Figure 14.1 and

explained previously, the company’s before-tax annual cost of capital rate is 22.3 percent ($2,230,000 required annual EBIT

÷ $10 million total capital invested in assets = 22.3% annual cost of capital rate). However, this cost-of-capital rate cannot be simply multiplied by the $500,000 cost of the cash regis-

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ters to determine the future returns needed from the investment. The cost-of-capital factors must be applied in a different manner.

Furthermore, the future returns from the investment have to recover the $500,000 capital invested in the cash registers. After five years of use the cash registers will be at the end of their useful lives to the business and will have no residual salvage value. In summary, the future returns have to be sufficient to recover the cost of the cash registers and to provide for the cost of capital each year over the life of the investment.