Prentice Hall's one-day MBA in finance & accounting (34 page)

Therefore, the present value of the investment must be exactly $500,000, which is the entry cost of the investment. Using the after-tax cost-of-capital rate to discount the returns from the investment proves this point.

As just calculated, the company’s after-tax cost-of-capital rate is 13.38 percent. Instead of applying this discount rate directly to the $172,463 returns (labor cost savings) from the investment, the annual returns are first converted to an after-tax basis, as though the returns were fully taxable at the 40

percent income tax rate. However, income tax is overstated because the depreciation deduction based on the cost of the assets is ignored. The depreciation tax effect is brought into the analysis as follows.

In this example, the straight-line depreciation method is used, so the company deducts $100,000 depreciation each year for income tax purposes. This reduces its taxable income
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and thus its income tax by $40,000 each year ($100,000

annual depreciation × 40% tax rate = $40,000 income tax savings). The depreciation tax savings are added to the $103,478

after-tax returns each year, which gives a total of $143,478 for each year. These annual amounts are discounted using the after-tax cost-of-capital rate as follows:

Present Value Calculations

Year 1 $143,478 ÷ (1 + 13.38%)1 = $126,546

Year 2 $143,478 ÷ (1 + 13.38%)2 = $111,612

Year 3 $143,478 ÷ (1 + 13.38%)3 = $ 98,441

Year 4 $143,478 ÷ (1 + 13.38%)4 = $ 86,824

Year 5 $143,478 ÷ (1 + 13.38%)5 = $ 76,577

Present value

= $500,000

The present value calculated in this manner equals the entry cost of the investment. (When the stream of future returns consists of uniform amounts, only one global calculation is required, but I show them for each year to leave a clear trail regarding how present value is calculated.) The company would earn exactly its cost of capital, because the present value equals the entry cost of the investment. This point also is demonstrated in Figure 14.3 in the previous chapter.

As I’ve said before, I favor a spreadsheet model for capital investment analysis over the equation-oriented DCF method.

A spreadsheet model is more versatile and provides more information for management analysis. Also, I think it is a more intuitive and straightforward approach.

REGARDING COST-OF-CAPITAL FACTORS

Most discourses on business capital investment analysis assume a constant mix, or ratio, of debt and equity over the life of an investment. And the cost of each source of capital is held constant over the life of the investment. Also, the income tax rate is held constant. Before spreadsheets came along, there were very practical reasons for making these assumptions, mainly to avoid using more than one cost-of-capital rate in the analysis. Today these constraints are no longer necessary.

If the situation calls for it, the manager should change the ratio of debt and equity from one period to the next or change
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the interest rate and/or the ROE rate from period to period.

Each period could be assigned its own cost-of-capital rate, in other words. Sometimes this is appropriate for particular capital investments. For instance, a capital investment may involve direct financing, in which a loan is arranged and tailor-made to fit the specific features of the investment.

One example of direct financing is when a business offers its customers the alternative of leasing products instead of buying them. The business makes an investment in the assets leased to its customers. The business borrows money to provide part of the capital invested in the assets leased to customers. The leased assets are used as collateral for the loan, and the terms of the loan are designed to parallel the terms of the lease. Over the life of the lease, the mix of debt and equity capital invested in the assets changes from period to period.

Furthermore, the interest rate on the lease loan and the ROE

goal for lease investments very likely are different from the cost-of-capital factors for the company’s main line of business.

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END POINT

This and the previous chapter explain the analysis of a business’s long-term investments in operating assets. The capital to make these investments comes from two basic sources—debt and owners’ equity. A business should carefully analyze capital investments to determine whether the investment will yield sufficient operating profit to provide for its cost of capital during the life of the investment. This chapter demonstrates how to use the spreadsheet model developed in the previous chapter for discounting the future returns from an investment to determine its present value. The chapter also presents a succinct survey of the commonly used mathematical techniques for analyzing business capital investments.

Discounted cash flow
is the broad generic name, or umbrella term, for the traditional equation-oriented capital investment analysis methods. A stream of future cash returns from an investment is discounted to calculate the present value, or the net present value, of the investment. Alternatively, the internal rate of return that the future returns would yield is determined. The IRR of an investment is compared against the company’s cost-of-capital rate and with the internal rates of return of alternative investments. These mathe-

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matical analysis techniques are explained in the chapter, while keeping the computational equations to a minimum.

The equation-oriented techniques were developed before sophisticated spreadsheet programs were available for personal computers. In my view, the spreadsheet model is a better analysis tool. Spreadsheets are more versatile, easier to follow, and make it possible to display all the relevant information for decision-making analysis and management control. Nevertheless, the traditional capital investment analysis methods probably will be around for some time.

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End Topics

C H A P T E R 16

1

Service Businesses

AAsk business consultants and I’d bet most would say that one of the first things new clients tell them is: “Our business is different.” Which is true, of course; every business is unique. On the other hand, all businesses draw on a common core of concepts, principles, and techniques. Take people: Every individual is different and unique. Yet basic principles of behavior and motivation apply to all of us. Take products: Breakfast cereals are different from computers, which are different from autos, and so on. Yet basic principles of marketing apply to all products and services.

Applying
basic business concepts and principles is the difficult part that managers are paid to do and do well. The manager must adapt the basic concepts and general principles to the specific circumstances of her or his particular business. Likewise, the tools and techniques of analysis demonstrated in previous chapters must be adapted and modified to fit the characteristics and problems of each particular business.

This chapter applies the profit analysis tools and techniques discussed in previous chapters to service businesses.

These business entities do not sell a product, or if a product is sold it is quite incidental to the service. There are very interesting differences in profit behavior between product and service businesses.

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E N D T O P I C S

FINANCIAL STATEMENT DIFFERENCES OF

SERVICE BUSINESSES

Service businesses range from dry cleaners to film processors, from hotels to hospitals, from airlines to freight haulers, from CPAs to barbers, from rental firms to photocopying stores, from newspapers to television networks, and from movie theaters to amusement parks. The service sector is the largest general category in the economy—although extremely diverse.

Nevertheless, a general example serves as a relevant framework for a large swath of service businesses. You can modify and tailor-fit this benchmark example to the particular characteristics of any service business.

I use a typical example for a product-oriented company in Chapter 4 to demonstrate the interpretation of externally reported financial statements. Instead of introducing a new example, the product business example is converted to a service company example to point out the basic differences between these two types of business. Figure 16.1 presents the income statement and balance sheet (statement of financial condition) for the product business with certain accounts crossed out. You don’t find these accounts in the financial statements of a service company.

A service company does not sell a product, so the inventories account and the inventory-dependent accounts are also crossed out. Accounts payable for inventories in the balance sheet is crossed out, but accounts payable for operating expenses remains. (In externally reported balance sheets, these two sources of accounts payable are blended into just one accounts payable liability account, but they are shown separately in Figure 16.1.) Minor differences in the statement of cash flows between product-based and service businesses are not shown in Figure 16.1.

In the income statement, the cost-of-goods-sold expense account and the gross margin profit line are crossed out.

Instead of cost of goods sold, most service businesses have comparatively larger fixed operating expenses relative to sales revenue than do product-based businesses.

As just mentioned, service businesses have no inventories. In the example shown in Figure 16.1, inven-

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S E R V I C E B U S I N E S S E S

Income Statement for Year Just Ended

Sales revenue

$39,661,250

Cost of goods-sold-expense

$24,960,750

Gross margin

$14,700,500

Selling and administrative expenses

$11,466,135

Earnings before interest and income tax

$ 3,234,365

Interest expense

$

795,000

Earnings before income tax

$ 2,439,365

Income tax expense

$

853,778

Net income

$ 1,585,587

Earnings per share

$

3.75

Balance Sheet at Close of Year Just Ended

Assets

Cash

$ 2,345,675

Accounts receivable

$ 3,813,582

Inventories

$ 5,760,173

Prepaid expenses

$

822,899

Total current assets

$12,742,329

Property, plant, and equipment

$20,857,500

Accumulated depreciation

($ 6,785,250)

Cost less accumulated depreciation

$14,072,250

Total assets

$26,814,579

Liabilities and Owners’ Equity

Accounts payable—inventories

$ 1,920,058

Accounts payable—operating expenses

$

617,174

Accrued expenses payable

$ 1,280,214

Income tax payable

$

58,650

Short-term debt

$ 2,250,000

Total current liabilities

$ 6,126,096

Long-term debt

$ 7,500,000

Total liabilities

$13,626,096

Capital stock (422,823 shares)

$ 4,587,500

Retained earnings

$ 8,600,983

Total Owners’ equity

$13,188,483

Total Liabilities and owners’ equity

$26,814,579

FIGURE 16.1
Items deleted for a service business (financial statements from Figures 4.1 and 4.2 for a product-based business).

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tories are almost $6 million, so if this were a service business its total assets would be $6 million less and its liabilities and owners’ equity would be $6 million less.

Some service businesses (airlines, gas and electric utilities, railroads) make heavy investments in long-term, fixed operat-

ing assets. These businesses are said to be
capital-intensive.

In the past, all three of these examples were regulated indus-

tries, but more recently they have been deregulated. In con-

trast, other types of service businesses (e.g., professional legal firms) make relatively light investments in fixed operating assets. Many service businesses are in the middle regarding capital invested in property, plant, and equipment. Examples are movie theater chains, newspapers, and book publishers.

They invest in long-term operating assets, but not huge amounts.

MANAGEMENT PROFIT REPORT

FOR A SERVICE BUSINESS

Figure 16.2 presents internal management reports for three profit modules of a service business, which are used through-

out the rest of the chapter. You may notice that this example closely follows the three-profit module example for the prod-

uct business in Chapter 9. My purpose is to provide compar-

isons between a middle-of-the-road source of revenue with an average profit margin (the standard service in Figure 16.2), a TEAMFLY

no-frills basic service with a slim profit margin, and a top-of-

the-line premier service with relatively high profit margin.

Just as product-based businesses sell different products with different margins, many service businesses offer different services at different prices. For example, airline companies offer first class, standard class, and tourist class. Entertain-

ment businesses charge different prices depending on where seats are located, as do football and baseball teams. Hotels charge different prices for rooms with a better view. And so on.

Compared with the management profit reports in Figure 9.1 for the product business example, the major changes in Figure 16.2 are the absences of cost-of-goods-sold expense and gross margin. As mentioned earlier, service businesses don’t sell products and therefore they don’t have a cost-of-