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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 busi-
ness. These long-term capital investments of a business are
just one part, though an important part to be sure, of a busi-
ness™s overall profit strategy and planning.

THE WHOLE BUSINESS VERSUS SINGULAR
CAPITAL INVESTMENTS
From the cost-of-capital viewpoint, the key criterion for guild-
ing 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 per-
cent 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 expen-
ditures 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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DETERMINING INVESTMENT RETURNS NEEDED


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 port-
folio. 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 ana-
lyzed 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 mark-
ing 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 pro-
vide better control over sales prices, which is another impor-
tant advantage. Some of the company™s cashiers frequently
punch in wrong prices in error; worse, some cashiers inten-
tionally 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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C A P I TA L I N V E S T M E N T A N A LY S I S


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, esti-
mating 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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DETERMINING INVESTMENT RETURNS NEEDED


ters to determine the future returns needed from the invest-
ment. 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.
Before moving on to the analysis of this capital investment,
I should mention that there would be several incentives to
invest in the cash registers. As already stated, the new cash
registers would eliminate data entry errors by cashiers and
would prevent cashiers from deliberately entering low prices
for their friends and relatives. Employee fraud is a common
and expensive problem, unfortunately. Also, the company may
anticipate that it will be increasingly difficult to hire qualified
employees over the next several years. Furthermore, the new
cash registers would enable the company to collect marketing
data on a real-time basis, which it cannot do at present. In
short, there are several good reasons for buying the cash reg-
isters. However, the following discussion focuses on the finan-
cial aspects of the investment decision.


Analyzing the Investment: First Comments
The first step is to make a ballpark estimate of how much the
future returns would have to be for the investment. The busi-
ness has to recover the capital invested in the cash registers,
which is $500,000 in the example. The business has five
years to recover this amount of capital. But clearly, future
returns of just $100,000 per year for five years is not enough.
This amount of yearly return would not cover the company™s
cost of capital each year. So to start the ball rolling, an annual
return of $160,000 is used in the analysis, which might seem
to be adequate to cover the company™s cost of capital. But is
$160,000 per year actually enough?

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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


First Pass at Analyzing the Investment
Figure 14.2 presents a spreadsheet analysis of the investment
in the new cash registers. (In the old days before personal
computers, this two-dimensional layout was called a work-
sheet.) This is only a first pass to see whether $160,000
annual returns on the investment would be sufficient. The
analysis may seem complex at first glance, but it is quite
straightforward. The method begins with the return for each
year and makes demands on the cash return.


The demands are four in number: (1) interest on debt
capital, (2) income tax, (3) ROE (return on equity), and
(4) recovery of capital invested in the assets. The first three
amounts must be calculated by fixed formulas each year. The
fourth is a free-floater; these amounts can follow any pattern
year to year. But their total over the five years must add to
$500,000, which is the amount of capital invested in the assets.
I™ll walk down the first-year column in some detail; the
other four years are simply repeats of the first year. The first
claim on the annual return (in this example, the labor cost
savings for the year) is for interest. For year 1, the interest
claim is $14,000 ($175,000 debt balance at start of year —
8.0% interest rate = $14,000 annual interest). The second
demand is for income tax. The annual labor cost savings
increase the company™s taxable income each year. Income tax
each year depends on the interest for the year, which is
deductible and on the depreciation method used for calculat-
ing income tax. As shown in Figure 14.2 the straight-line
depreciation method is used, which gives a $100,000 depreci-
ation deduction each year for five years using a zero salvage
value at the end of five years. (The accelerated depreciation
method could be used instead.)
The bottom layer in Figure 14.2 shows the calculation of
income tax for each year attributable to the investment. The
income tax for the year is entered above as the second takeout
from the annual labor cost savings. The third takeout from the
annual return is for earnings on equity capital (see Figure
14.2). The deduction for ROE is based on the ROE goal of 18.0
percent per year. ROE for year 1 equals $58,500 ($325,000
equity capital at start of year — 18.0% ROE = $58,500 net
income).

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DETERMINING INVESTMENT RETURNS NEEDED




Interest rate 8.0%
ROE 18.0% Cost-of-capital factors
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) ($ 12,065) ($ 9,872) ($ 7,384) ($ 4,564)
For income tax ($ 18,400) ($ 19,174) ($ 20,051) ($ 21,046) ($ 22,174)
For ROE ($ 58,500) ($ 50,415) ($ 41,249) ($ 30,856) ($ 19,072)
Equals capital
recovery $ 69,100 $ 78,346 $ 88,828 $100,713 $114,189
Cumulative capital
recovery at
end of year $ 69,100 $147,446 $236,274 $336,987 $451,176

Capital Invested at Beginning of Year
Debt $175,000 $150,815 $123,394 $ 92,304 $ 57,054
Equity $325,000 $280,085 $229,160 $171,422 $105,958
Total $500,000 $430,900 $352,554 $263,726 $163,013

Income Tax
EBIT increase $160,000 $160,000 $160,000 $160,000 $160,000
Interest expense ($ 14,000) ($12,065) ($ 9,872) ($ 7,384) ($ 4,564)
Depreciation ($100,000) ($100,000) ($100,000) ($100,000) ($100,000)
Taxable income $ 46,000 $ 47,935 $ 50,128 $ 52,616 $ 55,436
Income tax $ 18,400 $ 19,174 $ 20,051 $ 21,046 $ 22,174
FIGURE 14.2 Analysis of investment in cash registers, assuming $160,000
annual returns.




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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


As mentioned, the $160,000 annual cash returns amount
used in Figure 14.2 is just the starting point in the analysis.
This amount may not be enough to actually achieve the 18.0
percent annual ROE goal of the business. The purpose of the
analysis is to test whether the $160,000 annual returns would
be enough to achieve the ROE goal of the business. Of course,

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