Foundations of Financial Management: An Analysis (part 49)

“Most people work just hard enough not to get fired and get paid just enough money not to quit.” 

– George Carlin

The Capital Budgeting Decision (Part E)

by

Charles Lamson

Actual Investment decision

Table 10 Depreciation Schedule

Assume in the $50,000 depreciation analysis shown in Table 10 (from last post and reintroduced above) that we are given additional facts and asked to make an investment decision about whether an asset should be purchased or not. We shall assume we are purchasing a piece of machinery that will have a 6-year productive life. It will produce income of $18,500 for the first three years before deductions for depreciation and taxes. In the last three years, the income before depreciation and taxes will be $12,000. Furthermore, we will assume a corporate tax rate of 35 percent and a cost of capital of 10 percent for the analysis. The annual cash flow related to the machinery is presented in Table 11. For each year we subtract depreciation from "earnings before depreciation and taxes" to arrive at earnings before taxes. We then subtract the taxes to determine earnings after taxes. Finally depreciation is added to earnings after taxes to arrive at cash flow. The cash flow starts at $15,525 in the first year and ends at $8,815 in the last year.

Table 11 Cash flow related to the purchase of machinery

Having determined the annual cash flows, we now are in a position to discount the values back to the present at the previously specified cost of capital, 10 percent. The analysis is presented in Table 12. At the bottom of the same table, the present value of the inflows is compared to the present value of the outflows (simply the cost of the asset) to arrive at a net present value of $7,991. On the basis of the analysis, it appears that the asset should be purchased.

Table 12 Net present value analysis

The Replacement Decision

So far this analysis has centered on an investment that is being considered as a net addition to the present plant and equipment. However, many investment decisions occur because of new technology, and these are considered replacement decisions. The financial manager often needs to determine whether a new machine with advanced technology can do the job better than the machine being used at present.

These replacement decisions include several additions to the basic investment situation. For example we need to include the sale of the old machine in our analysis. This sale will produce a cash inflow that partially offsets the purchase price of the new machine. In addition the sale of the old machine will usually have tax consequences. Some of the cash inflow from the sale will be taxable if the old machine is sold for more than book value. If it is sold for less than book value, this will be considered a loss and will provide a tax benefit.

The replacement decision can be analyzed by using a total analysis of both the old and new machines or by using an incremental analysis that emphasizes the changes in cash flows between the old and new machines. We will emphasize the incremental approach. 

Assume the Lamson Corporation purchased a computer two years ago for $120,000. The asset is being depreciated under the five-year MACRS schedule shown in Table 9 from last post (and reintroduced below), which implies a six-year write-off because of the half-year convention. We will assume the old computer can be sold for $37,600. A new computer will cost $180,000 and will also be written off using the 5-year MACRS schedule in Table 9.

The new computer will provide cost savings and operating benefits, compared to the old computer, or $42,000 per year for the next 6 years. These cost savings and operating benefits are the equivalent of increased earnings before depreciation and taxes. The firm has a 35 percent tax rate and a 10 percent cost of capital. First we need to determine the net cost of the new computer. We will take the purchase price of the new computer $180,000 and subtract the cash inflow from the sale of the old computer.

Sale of Old Asset

The cash inflow from the sale of the old computer is based on the sales price as well as the related tax factors. To determine these tax factors, we first compute the book value of the old computer and compare this figure to the sales price to determine if there is a taxable gain or loss. The book value of the old computer is shown in Table 13.

Table 13 Book value of old computer

Since the book value of the old computer is $57,600 and the sales price previously given is $37,600 there will be a $20,000 loss.

This loss can be written off against other income for the corporation. The Lamson Corporation has a 35 percent tax rate, so the tax write-off is worth $7,000.

We now add the tax benefit to the sale price to arrive at the cash inflow from the sale of the old computer.

The computation of the cash inflow figure from the old computer allows us to compute the net cost of the new computer. The purchase price of $180,000, minus the cash inflow from the sale of the old computer, provides the value of $135,400 as indicated in Table 14.

Table 14 Net cost of new computer

The question then becomes: Are the incremental gains from the new computer compared to those of the old computer large enough to justify the net cost of $135,400? We will assume that both will be operative over the next six years, although the old computer will run out of depreciation in four more years. We will base our cash flow analysis on (a) the incremental gain in depreciation and the related tax shield benefits and (b) cost savings.

Incremental Depreciation

The annual depreciation on the new computer will be: 

The annual depreciation on the old computer for the remaining 4 years would be:

In Table 15, we bring together the depreciation on the old and new computers to determine incremental depreciation and the related tax benefits. Since depreciation shields other income from being taxed, the benefits of the tax shield are worth the amount being depreciated times the tax rate. For example in year one, $12,960 in incremental depreciation will keep $12,960 from being paid, and with the firm in a 35 percent tax bracket, this represents a tax savings of $4,536. The same type of analysis applies to each subsequent year.

Table 15 Analysis of incremental depreciation benefits

Cost Savings

The second type of benefit relates to cost savings from the new computer. As previously stated the savings are assumed to be $42,000 for the next 6 years. The aftertax benefits are shown in table 16.

Table 16 Analysis of incremental cost savings benefits

As indicated in Table 16, we take the cost-savings in column 2 and multiply by 1 minus the tax rate. This indicates the value of the savings on an aftertax basis.

We now combine the incremental tax shield benefits from depreciation (Table 15) and the aftertax cost savings (Table 16) to arrive at total annual benefits in Tables 17 (column 4). These benefits are discounted to the present at a 10 percent cost of capital. The present value of the inflows is $150,950 as indicated at the bottom of column 6 in Table 17.

Table 17 Present value of the total incremental benefits

We are now in a position to compare the present value of incremental benefits of $150,950 from table 17 to the net cost of the new computer of $135,400 from table 14.

Clearly there is a positive net present value, and the purchase of the computer should be recommended on the basis of the financial analysis. 

Elective Expensing

I have stressed throughout these last several posts covering the capital budgeting decision the importance of taking deductions as early in the life of the asset as possible. Since a tax deduction reduces cash flow, the earlier you can get the cash flow the better. Businesses can actually write off tangible property, such as equipment, furniture, tools, and computers, in the year they are purchased for up to $100,000. This is clearly superior to depreciating the asset where the write off must take place over a number of years. This feature of elective expensing is primarily beneficial to small businesses because the allowance is phased out dollar for dollar when total property purchases exceed $200,000 in a year. Thus a business that purchases $300,000 in assets for the year no longer has this option.

Summary

The capital budgeting decision involves the planning of expenditures for a project with a life of at least one year and usually considerably longer. Although top management is often anxious about the impact of their decisions on short-term reported income, the planning of capital expenditures dictates a longer time horizon.

Because capital budgeting deals with actual dollars rather than reported earnings, cash flow instead of operating income is used in the decision.

Three primary methods are used to analyze capital investment proposals: the payback method, the internal rate of return, and the net present value. The first method is unsound, while the last two are acceptable, with net present value deserving our greatest attention. The net present value method uses the cost of capital as the discount rate. And using the cost of capital as the discount, or hurdle rate, we affirm that a project must at least earn the cost of funding to be acceptable as an investment.

As demonstrated throughout these past several posts covering the capital budgeting decision, the two forms of benefits attributed to an investment are (a) aftertax operating benefits and (b) the tax shield benefits of depreciation. The present value of these inflows must exceed the investment for a project to be acceptable. 

*MAIN SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, 11TH ED., PP. 365-373*

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