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


assets (trucks, equipment, machinery, computers, telephone
systems, etc.) can be leased, either directly from the manufac-
turer 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 busi-
ness, 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. Compli-
cating matters is the fact that the term of the lease and pat-
tern 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 opportu-
nity 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 posses-
sion and use of the assets as if it had bought them outright.
For example, the retailer would pay the fire and theft insur-
ance on the assets whether they are owned or leased. By leas-
ing the cash registers, the retailer would reduce its annual


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DETERMINING INVESTMENT RETURNS NEEDED


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


A WORD ON CAPITAL BUDGETING
In theory, a business should assemble all its possible investment
opportunities, compare them, and rank-order them. The busi-
ness should select the one with the highest ROE first, and so on.
In allocating scarce capital among competing investment oppor-
tunities, 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 manage-
ment 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 actu-
ally 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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DETERMINING INVESTMENT RETURNS NEEDED




CHAPTER APPENDIX



Interest rate 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
recovery at
end of year $ 79,951 $168,864 $267,744 $377,709 $500,000

Capital Invested at Beginning of Year
Debt $175,000 $147,017 $115,898 $ 81,290 $ 42,802
Equity $325,000 $273,032 $215,238 $150,966 $ 79,489
Total $500,000 $420,049 $331,136 $232,256 $122,291

Income Tax
EBIT increase $160,000 $160,000 $160,000 $160,000 $160,000
Interest expense ($ 14,000) ($ 11,761) ($ 9,272) ($ 6,503) ($ 3,424)
Depreciation ($100,000) ($100,000) ($100,000) ($100,000 ($100,000)
Taxable income $ 46,000 $ 48,239 $ 50,728 $ 53,497 $ 56,576
Income tax $ 18,400 $ 19,295 $ 20,291 $ 21,399 $ 22,630
FIGURE 14.5 Exact ROE rate for cash registers capital investment with
$160,000 annual returns.




211
15
CHAPTER




Discounting
Investment Returns
Expected


T
This chapter and Chapter 14 are like a set of bookends. Chap-
ter 14 explains the analysis of long-term investments in oper-
ating assets by businesses. This chapter continues the topic,
with one key difference.
The time line of analysis in the previous chapter goes like
this:
Present Future
Starting with a given amount of capital invested today, the
analysis looks forward in time to determine the amounts of
future returns that would be needed in order to satisfy the
cost-of-capital requirements of the business.
The time line of analysis in this chapter goes like this:
Present Future
Starting with the amounts of future returns from an invest-
ment (which are treated as fixed) the analysis travels back-
ward in time to determine an amount called the present value
of the investment. The present value is the most that a busi-
ness should be willing to invest today to receive the future
returns from the investment, based on its cost-of-capital
requirements. The present value is compared with the entry
cost of an investment.



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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



TIME VALUE OF MONEY AND COST
OF CAPITAL
The pivotal idea in this and the previous chapter is the time
value of money. This term refers not only to money but also
more broadly to capital and economic wealth in general. Capi-
tal should generate income, gain, or profit over the time it is
used. The ratio of earnings on the capital invested over a
period of time, one year being the standard time period of ref-
erence, is the measure for the time value of money. Karl Marx
said that capital is “dead labor” and argued that capital
should be publicly owned for the good of everyone. I won™t
pursue this economic philosophy any further. Quite clearly, in
our economic system capital does have a time value”or a
time cost depending on whose shoes you™re standing in.
The business example in Chapter 14 has the following capi-
tal structure and cost-of-capital factors:
Y
Capital Structure and Cost-of-Capital Factors
FL
• 35 percent debt and 65 percent equity mix of capital sources
• 8.0 percent annual interest rate on debt
AM


• 40 percent income tax rate (combined federal and state)
• 18.0 percent annual ROE objective
The same business example is continued this chapter. The
TE


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