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Cumulative capital

recovery at

end of year

$ 76,578

$163,401

$261,842

$373,454

$500,000

Capital Invested at Beginning of Year

Debt

$175,000

$148,198

$117,810

$ 83,355

$ 44,291

Equity

$325,000

$275,225

$218,789

$154,803

$ 82,255

Total

$500,000

$423,422

$336,599

$238,158

$126,546

Income Tax

EBIT increase

$172,463

$172,463

$172,463

$172,463

$172,463

Interest expense ($ 14,000) ($ 11,856) ($ 9,425) ($ 6,668) ($ 3,543) Depreciation

($100,000) ($100,000) ($100,000) ($100,000) ($100,000) Taxable income

$ 58,463

$ 60,607

$ 63,038

$ 65,794

$ 68,919

Income tax

$ 23,385

$ 24,243

$ 25,215

$ 26,318

$ 27,568

FIGURE 14.3
Exact amount of future returns required for investment.

$100,000 (using the straight-line method) but the capital recovery for the first year is $76,578. Both the total depreciation over the five years and the total capital recovery over the five years are $500,000. But the two amounts differ from year to year. This disparity is typical of capital investments and
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does not present a problem when using a spreadsheet model for analysis. (The difference between these two factors is much more of a nuisance in using the mathematical analysis techniques discussed in the Chapter 15.)

FLEXIBILITY OF A SPREADSHEET MODEL

As mentioned before, any factor in the analysis can be changed to test how sensitive the annual returns would be to the change. For instance, instead of the straight-line method the accelerated depreciation method could be used in calculating income tax. Instead of uniform labor cost savings across the years, returns could be set lower in the early years and higher in the later years—or vice versa. The debt-to-equity ratio can be shifted. Of course, the interest rate and ROE target rate can be changed. Once a change is entered, the effects of the change are instantly available on screen.

To illustrate an alternative scenario for the cash registers example, assume the following cost of capital situation for the retailer instead of the preceding example:

Capital Structure and Cost of Capital Factors

• No debt; 100 percent equity source of capital

• Annual interest rate on debt—not applicable

• 40 percent income tax rate

• 18.0 percent annual ROE objective

In this alternative scenario, the business uses no debt capital; all its capital comes from equity sources (capital invested by its shareowners and retained earnings). The ROE target rate is the same as before (18 percent annual ROE). Figure 14.4

shows the annual returns that would be needed in this situation. The required annual returns would jump to $199,815

compared with $172,463 in the earlier example, an increase of more than $27,000 per year! This is a rather significant increase. The capital structure of the business makes a difference on the future returns needed from an investment.

LEASING VERSUS BUYING LONG-TERM ASSETS

Business managers have opportunities for leasing instead of buying long-term operating assets. Most long-term operating
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Interest rate

0.0%

ROE

18.0%

Cost-of-capital factors

Income tax rate

40.0%

Debt % of capital

0.0%

Equity % of capital

100.0%

Year 1

Year 2

Year 3

Year 4

Year 5

Annual Returns

Labor cost savings $199,815

$199,815

$199,815

$199,815

$199,815

Distribution of Returns

For interest

$

0

$

0

$

0

$

0

$

0

For income tax

($ 39,926) ($ 39,926) ($ 39,926) ($ 39,926) ($ 39,926) For ROE

($ 90,000) ($ 77,420) ($ 62,576) ($ 45,059) ($ 24,390) Equals capital

recovery

$ 69,889

$ 82,469

$ 97,313

$114,830

$135,499

Cumulative capital

recovery at

end of year

$ 69,889

$152,358

$249,671

$364,501

$500,000

Capital Invested at Beginning of Year

Debt

$

0

$

0

$

0

$

0

$

0

Equity

$500,000

$430,111

$347,642

$250,329

$135,499

Total

$500,000

$430,111

$347,642

$250,329

$135,499

Income Tax

EBIT increase

$199,815

$199,815

$199,815

$199,815

$199,815

Interest expense

$

0

$

0

$

0

$

0

$

0

Depreciation

($100,000) ($100,000) ($100,000) ($100,000 ($100,000) Taxable income

$ 99,815

$ 99,815

$ 99,815

$ 99,815

$ 99,815

Income tax

$ 39,926

$ 39,926

$ 39,926

$ 39,926

$ 39,926

FIGURE 14.4
Future returns required from investment for an alternative
scenario (all equity, no debt).

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assets (trucks, equipment, machinery, computers, telephone systems, etc.) can be leased, either directly from the manufacturer of the asset or indirectly through a third-party leasing specialist. The cash registers probably could be leased instead of purchased. Leasing may be very appealing if the business is short of cash.

Perhaps the lessor has a lower cost of capital than the business, in which case the business might be better off leasing rather than investing its own capital in the assets. Then again, the lessor’s cost of capital may be higher, which means that the lease rents would be higher than the returns needed by the business based on its lower cost-of-capital rate. Complicating matters is the fact that the term of the lease and pattern of lease rents may differ from the stream of returns generated from the assets.

Also, leases typically offer a purchase option at the end of the lease, at which time the business can purchase the assets.

And leases are very complicated legal contracts that generally impose all kinds of conditions and constraints on the lessee.

Many leases involve front-end cash outlays by the lessee. In short, comparing the purchase of long-term assets against leasing the same assets can be very difficult—like comparing apples and oranges.

But to illustrate certain basic points regarding the lease-versus-buy decision, suppose the retailer had the opportunity to lease the cash registers instead of buying them.

Suppose the lessor quotes monthly rents of $14,372 for five years, which equals a total annual rent of $172,463. I selected this rent amount to equal the amount of the annual labor cost savings for the business to earn 18.0 percent ROE

(see Figure 14.3). Also assume that the business would have the option to purchase the cash registers for a nominal amount at the end of the five-year lease. Thus the business would end up in the same position as if it had purchased the assets to begin with.

Generally, the lessee (the retailer) bears all costs of possession and use of the assets as if it had bought them outright.

For example, the retailer would pay the fire and theft insurance on the assets whether they are owned or leased. By leasing the cash registers, the retailer would reduce its annual
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labor costs by $172,463, but would pay annual lease rents of the same amount. From the financial point of view, leasing versus buying is a standoff in this case. The retailer may not have any other investment opportunities that would generate an annual 18.0 percent ROE. So if it has the money, the retailer may prefer to make the investment instead of leasing the cash registers, thus employing its capital and earning an annual 18.0 percent ROE on the investment.

Leases involve certain considerations beyond just the financial aspects. For one thing, the retailer may prefer not to assume the economic risks of owning the cash registers. In a fast-changing technological environment, a business may be reluctant to assume the risks making long-term investments in assets that may become obsolete in two or three years. So a business may shop around for a two- or three-year lease.

The simplest analysis situation for comparing leasing with buying assets is this. Suppose a business has identified a promising opportunity for which it needs to acquire certain assets that would generate a stream of future returns for so many years, say $150,000 per year for seven years. (This forecast of future returns may turn out to be too optimistic, of course.) Assume that the business is short of cash and that it has tapped out its capital sources. It would be difficult for the business to raise additional capital. Assume that a leasing specialist is willing to rent the assets to the business for $10,000 per month, or $120,000 per year for five years. At the end of the lease the business would have the option to purchase the assets for a nominal amount.

In this scenario the lease makes sense, keeping in mind the risk that the future returns may turn out to be lower than $150,000 per year. The business would realize a $30,000 gain in its operating profit each year ($150,000 annual returns from using the assets − $120,000 annual lease rents =

$30,000 net gain). This is the simplest way to analyze leases.

In actual situations the analysis is much more complicated. In any case, a business should determine the stream of future returns from acquiring the assets. If the assets are purchased, the returns provide the money to recover the capital invested in the assets and cover the business’s cost of capital along the way. If the assets are leased, the returns provide the money to pay the lease rents.

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A WORD ON CAPITAL BUDGETING

In theory, a business should assemble all its possible investment opportunities, compare them, and rank-order them. The business should select the one with the highest ROE first, and so on.

In allocating scarce capital among competing investment opportunities, ROE is the key criterion. According to this view of the world, the job of the business manager is to ration a limited amount of capital among competing investment alternatives.

The premise of rationing scarce capital resources is why the general topic of capital investment analysis is sometimes called
capital budgeting.
The term
budgeting
here is used in the allocation or apportionment sense, not in the sense of overall business management planning and goal setting. The comparative analysis of competing investment alternatives is beyond the scope of this book. Corporate financial management books cover this topic in depth.

s

END POINT

Business managers make many long-term capital investment decisions. The analysis of capital investments hinges on the cost-of-capital requirements of the business, which depend on the company’s mix of debt and equity capital, the cost of each, and the income tax situation of the business. The cost of equity capital is not a contractual rate like interest. Management decides on the ROE (return on equity) objective for the business.

Based on the amount of capital invested, a manager can determine the amounts of future returns that will be needed to satisfy the cost-of-capital requirements of the business. The manager has to judge whether these future returns can actually be achieved. The chapter explains how to apply the cost-of-capital imperatives of a business in making capital investment decisions. A spreadsheet model is used to analyze and illustrate a prototype capital investment. A spreadsheet model has two important advantages: It is an excellent device for organizing and presenting the relevant information for an investment, and it is a versatile tool for examining different scenarios of an investment.

Analysis is important, to be sure. But we should not get carried away. More important is the ability of managers to find good capital investment opportunities and blend them into the overall strategic plan of the business.

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8.0%

ROE

14.6613%

Exact ROE rate solved for in this figure

Income tax rate

40.0%

Debt % of capital

35.0%

Equity % of capital

65.0%

Year 1

Year 2

Year 3

Year 4

Year 5

Annual Returns

Labor cost savings $160,000

$160,000

$160,000

$160,000

$160,000

Distribution of Returns

For interest

($ 14,000) ($ 11,761) ($ 9,272) ($ 6,503) ($ 3,424) For income tax

($ 18,400) ($ 19,295) ($ 20,291) ($ 21,399) ($ 22,630) For ROE

($ 47,649) ($ 40,030) ($ 31,557) ($ 22,134) ($ 11,654) Equals capital

recovery

$ 79,951

$ 88,913

$ 98,880

$109,964

$122,291

Cumulative capital