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during the period from improving profit can be, and usually
is, significantly different than the gain in profit. Indeed, the
chapter demonstrates that in certain situations the cash flow
effect can be negative from increasing profit. Managers need a
good handle on both the profit effect and the cash flow effect
from changing profit factors.

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4
PA R T




Capital
Investment
Analysis
14
CHAPTER




Determining
Investment Returns
Needed


T
This chapter explains how the cost of capital is factored into
the analysis of business investments to determine the future
returns needed from an investment. An investment has to pay
its way. The future returns from an investment should recover
the capital put into the investment and provide for the cost of
capital during each period along the way. The future returns
should do at least this much. If not, the investment will turn
out to be a poor decision; the capital should have been
invested elsewhere.

The analysis in this chapter is math-free. No mathematical
equations or formulas are involved. I use a computer spread-
sheet model to illustrate the analysis and to do the calculations.
The main example in the chapter provides a general-purpose
template that can be easily copied by anyone familiar with a
spreadsheet program. However, you don™t have to know any-
thing about using spreadsheets to follow the analysis.


A A BUSINESS AS AN ONGOING
Remember INVESTMENT PROJECT
Chapter 5 explains that a business needs a portfolio of
assets to carry on its profit-making operations. For the capi-
tal needed to invest in its assets, a business raises money

191
C A P I TA L I N V E S T M E N T A N A LY S I S


from its owners, retains all or part of its annual earnings, and
borrows money. The combination of these three sources con-
stitutes the capital structure, or capitalization, of a business.
Taken together, the first two capital sources are called owners™
equity, or just equity for short. Borrowed money is referred to
as debt. Interest is paid on debt, as you know. Its shareowners
expect a business to earn an annual return on their equity at
least equal to, and preferably higher than, what they could
earn on alternative investment opportunities for their capital.


COST OF CAPITAL
A business™s earnings before interest and income tax
(EBIT) for a period needs to be sufficient to do three things:
(1) pay interest on its debt, (2) pay income tax, and (3) leave
residual net income that satisfies the shareowners of the busi-
ness. Based on the total amount of capital invested in its
assets and its capital structure, a business determines its
EBIT goal for the year. For instance, a business may establish
an annual EBIT goal equal to 20 percent of the total capital
invested in its assets. This rate is referred to as its cost of
capital.
The annual cost-of-capital rate for most businesses is in the
range of 15 to 25 percent, although there is no hard-and-fast
standard that applies to all businesses. The cost-of-capital rate
depends heavily on the target rate for net income on its own-
ers™ equity adopted by a business. The interest rate on a busi-
ness™s debt is definite, and its income tax rate is fairly definite.
On the other hand, the rate of net income set by a business as
its goal to earn on owners™ equity is not definite. A business
may adopt a rather modest or a more aggressive benchmark
for earnings on its equity capital.
Of course, a business may fall short of its cost-of-capital
DANGER!
goal. Its actual EBIT for the year may be enough to pay its
interest and income tax, but its residual net income may be
less than the business should earn on its owners™ equity for
the year. For that matter, a business may suffer an operating
loss and not even cover its interest obligation for the year. One
reason for reporting financial statements to outside shareown-
ers and lenders is to provide them with information so they
can determine how the business is performing as an investor,
or user of capital.

192
DETERMINING INVESTMENT RETURNS NEEDED


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 busi-
nesses, 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 con-
densed 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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C A P I TA L I N V E S T M E N T A N A LY S I S




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.
Y
The cost of equity capital is a much different matter. On its
FL
$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
AM


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
TE




taxable income the company keeps only 60¢ because the
income tax rate is 40 percent, or 40¢ on the dollar. On
$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 (earn-
ings 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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DETERMINING INVESTMENT RETURNS NEEDED


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 resid-
ual 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 invento-
ries 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 invest-
ment is accounts receivable. Accounts receivable will be col-
lected 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 con-
tinue 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, machin-
ery and equipment, furniture, fixtures, tools, computers,
vehicles, and so on. A business also may make long-term
investments in intangible assets”patents and copyrights, cus-
tomer lists, computer software, established brand names and
trademarks developed by other companies, and so on. The cap-
ital 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 compo-
nent 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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C A P I TA L I N V E S T M E N T A N A LY S I S



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 deci-
sions 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

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