Accounting: The Language of Business - Vol. 1 (Part 158 - Conclusion)

Go is to Western chess what philosophy is to double-entry accounting.

Trevanian

Capital Investment Analysis (Part D)

by

Charles Lamson

Factors that Complicate Capital Investment Analysis

In parts 156 and 157, we described four widely used methods of evaluating capital investment proposals. In practice, additional factors may have an impact on the outcome of a capital investment decision. In the following paragraphs, we discuss some of the most important of these factors: the federal income tax, unequal lives of alternative proposals, leasing, uncertainty, changes in price levels, and qualitative factors.

Income Tax

In many cases, the impact of the federal income tax on capital investment decisions can be material. For example, in determining depreciation for federal income tax purposes, useful lives that are much shorter than the actual useful lives are often used. Also, depreciation can be calculated by methods that approximate the 200-percent declining-balance method. Thus, depreciation for tax purposes often exceeds the depreciation for financial statement purposes in the early years of an asset's use. The tax reduction in these early years is offset by higher taxes in the later years, so that accelerated depreciation does not result in a long-run saving in taxes. However, the timing of the cash outflows for income taxes can have a significant impact on capital investment analysis.

Unequal Proposal Lives

In the preceding discussion, the illustrations of the methods of analyzing capital investment proposals were based on the assumption that alternative proposals had the same useful lives. In practice, however, alternative proposals may have unequal lives. To illustrate, assume that alternative investments, a truck and computers, are being compared. The truck has a useful life of 8 years, and the computer network has a useful life of 5 years. Each proposal requires an initial investment of $100,000, and the company desires a rate of return of 10%. The expected cash flows and net present value of each alternative are shown in Exhibit 4. Because of the unequal useful lives of the two proposals, however, the net present values in Exhibit 4 are not comparable.

EXHIBIT 4 Net Present Value Analysis---Unequal Lives of Proposals

To make the proposals comparable for the analysis, they can be adjusted to end at the same time. This can be done by assuming that the truck is to be sold at the end of 5 years. The residual value (the estimated value of a fixed asset at the end of its lease term or useful life) of the truck must be estimated at the end of 5 years, and this value must then be included as a cash flow at that date. Both proposals will then cover 5 years, and net present value analysis can be used to compare the two proposals over the same five-year period. If the truck's estimated residual value is $40,000 at the end of year five years, the net present value for the truck exceeds the net present value for the computers by $1,835 ($18,640 - $16,805), as shown in Exhibit 5. Therefore, the truck may be viewed as the more attractive of the two proposals.

Lease vs Capital Investment

Leasing fixed assets has become common in many Industries. For example, hospitals often lease diagnostic and other medical equipment. Leasing allows a business to use fixed assets without spending large amounts of cash to purchase them. In addition, management may believe that a fixed asset has a high risk of becoming obsolete. This risk may be reduced by leasing rather than purchasing the asset. Also, the Internal Revenue Code allows the lessor (the owner of the asset) to pass tax deductions on to the lessee (the party leasing the asset). These provisions of the tax law have made leasing assets more attractive. For example, a company that pays $50,000 per year for leasing a $200,000 fixed asset with a life of eight years is permitted to deduct from taxable income the annual lease payments.

In many cases, before a final decision is made, management should consider leasing assets instead of purchasing them. Normally, leasing assets is more costly than purchasing because the lessor must include in the rental price not only the costs associated with owning the assets but also a profit. Nevertheless, using the methods of evaluating capital investment proposals, management should consider whether it is more profitable to lease rather than purchase an asset.

Uncertainty

All capital investment analyses rely on factors that are uncertain. For example, the estimates related to revenues expenses, and cash flows are uncertain. The long-term nature of capital investments suggests that some estimates are likely to involve uncertainty. Errors in one or more of the estimates could lead to incorrect decisions.

Changes in Price Levels

In performing investment analysis, management must be concerned about changes in price levels. Price levels may change due to inflation, which occurs when the general price levels are rising. Thus, while general prices are rising, the returns on an investment must exceed the rising price level, or else the cash returned on the investment becomes less valuable over time.

Price levels may also change for foreign investments as the result of currency exchange rates. Currency exchange rates are the rates at which currency in another country can be exchanged for U.S. dollars. If the amount of local dollars that can be exchanged for one U.S. dollar increases, then the local currency is said to be weakening to the dollar. Thus, if a company made an investment in another country where the local currency was weakening, it would adversely impact the return on that investment as expressed in U.S. dollars. This is because the expected amount of local currency returned on the investment would purchase fewer U.S. dollars.

Management should attempt to anticipate future price levels and consider their effects on the estimates used in capital investment analyses. Changes in anticipated price levels could significantly affect the analyses.

Qualitative Considerations

Some benefits of capital investments are qualitative in nature and cannot be easily estimated in dollar terms. If management does not consider these qualitative considerations, the quantitative analyses may suggest rejecting a worthy investment.

Qualitative considerations in capital investment analysis are most appropriate for strategic investments. Strategic investments are those that are designed to affect the company's long-term ability to generate profits. Strategic investments often have many uncertainties and intangible benefits. Unlike capital investments that are designed to cut costs, strategic investments have very few "hard" savings. Instead, they may affect future revenues, which are difficult to estimate. An example of a strategic investment is Nucor's decision to be the first to invest in a new continuous casting technology that had the potential to make thin gauge sheet steel and thus open new product markets (2005). Nucor's new investment was justified more on the strategic importance of the investment than on the end economic analysis. As it turned out, that investment was very successful.

Quantitative considerations that may influence capital investment analysis include product quality, manufacturing flexibility, employee morale, manufacturing productivity, and market opportunity. Many of these qualitative factors may be as important, if not more important, than the results of quantitative analysis. 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 1045-1048*

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