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


and thus its income tax by $40,000 each year ($100,000
annual depreciation — 40% tax rate = $40,000 income tax sav-
ings). 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
= $500,000
Present value
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 calcula-
tion 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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DISCOUNTING INVESTMENT RETURNS EXPECTED


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 pro-
vide part of the capital invested in the assets leased to cus-
tomers. 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.



s
END POINT
This and the previous chapter explain the analysis of a busi-
ness™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 tech-
niques 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. Alterna-
tively, 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 inter-
nal rates of return of alternative investments. These mathe-

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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


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 per-
sonal computers. In my view, the spreadsheet model is a bet-
ter analysis tool. Spreadsheets are more versatile, easier to
follow, and make it possible to display all the relevant infor-
mation for decision-making analysis and management con-
trol. Nevertheless, the traditional capital investment analysis
methods probably will be around for some time.




228
5
PA R T




End Topics
16
CHAPTER




Service Businesses




A
Ask business consultants and I™d bet most would say that one
of the first things new clients tell them is: “Our business is dif-
ferent.” Which is true, of course; every business is unique. On
the other hand, all businesses draw on a common core of con-
cepts, principles, and techniques. Take people: Every individ-
ual 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. Like-
wise, 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 tech-
niques 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 inter-
esting differences in profit behavior between product and
service businesses.


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END TOPICS


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 inven-
tories. In the example shown in Figure 16.1, inven-

232
SERVICE BUSINESSES




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 state-
ments from Figures 4.1 and 4.2 for a product-based business).



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