For the past 52 years, Harold Averkamp (CPA, MBA) has worked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online. He is the sole author of all the materials on AccountingCoach.com.
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Introduction
Businesses often face the need to spend large amounts of money on assets that will be functional for many years. Here are a few examples:
Equipment to improve an unsafe work situation or to protect the environment
Equipment to test the consistency of products as required by the customer
Equipment to package, label, and ship products according to the customer’s specifications
Equipment to reduce labor costs and improve the quality of products
Purchase of a building instead of leasing space
Expenditures made for long-term assets are referred to as capital expenditures and are recorded as assets on the balance sheet. During the years that these assets (other than land) are used, their costs are systematically moved from the balance sheet to the income statement through Depreciation Expense.
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Capital Budgeting
Limitations such as time, money, and logistics frequently prevent a company from moving forward with too many major expenditure projects at the same time. Instead, a company will often rank its projects by priority and profitability. By using a process called capital budgeting, the company decides which capital expenditure projects will be undertaken and when.
At the top of the list of capital expenditure projects are those for which no real choice exists (e.g., installing an updated sewer line within the plant to replace one that is leaking, correcting a safety hazard, correcting a code violation, etc). The remaining capital expenditures are usually ranked according to their profitability using a capital budgeting model.
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Capital Budgeting Models
There are a number of capital budgeting models available that assess and rank capital expenditure proposals. Let’s take a look at four of the most common models for evaluating business investments:
While each of these models has its benefits and drawbacks, sophisticated financial managers prefer the net present value and the internal rate of return methods. There are two reasons why these models are favored: (a) all of the cash flows over the entire length of the project are considered, and (b) the future cash flows are discounted to reflect the time value of money.
The following table highlights the differences among the four models:
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Evaluating Capital Expenditures
Let’s use the capital budgeting models to evaluate a potential business investment at Treeline Manufacturing, Inc.:
Treeline Manufacturing must decide whether or not it should buy a new machine to replace its existing machine. Because the new machine is faster, it would eliminate the need for a worker now employed to run the existing machine during the evening shift. The initial annual savings are expected to be $24,000, with future cost savings expected to increase $1,000 or more per year.
The old machine is fully depreciated and would be scrapped with no expected salvage value (no proceeds).
The new machine costs $100,000 and is expected to have no salvage value at the end of its useful life of 8 years. For purposes of financial reporting, the machine would be depreciated over its 8-year life using the straight-line method. For income tax reporting, it would be depreciated over 7 years using the accelerated method. The company’s income tax rate (federal and state combined) is 30%.
The new machine would be placed into service on January 1 and a full year of depreciation expense would be recorded on the financial statements during the first year. For income tax purposes our analysis uses a half-year of depreciation during the first year.
The relevant accrual basis of accounting amounts have been identified as follows (the relevant cash flow amounts will be shown later):
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Noncash, Nondiscounted Model
1. Accounting Rate of Return
This method of evaluating business investments considers the profitability of a project based on accrual accounting amounts found in the financial statements. The drawback of the accounting rate of return is that the net income amounts are not adjusted for the time value of money. In other words, $10,000 of net income in Year 4 is considered to be as valuable as $10,000 of net income in Year 1.
If the new machine is purchased, Treeline’s income statements will show a reduction of labor expense of about $24,000 in Year 1 and $31,733 in Year 8—an average of $27,729 during the 8 years. The income statements will also show additional depreciation expense of about $12,500 per year (the $100,000 cost of the machine and a useful life of 8 years with no salvage value). The net result of the average annual labor savings of $27,729 minus the additional annual depreciation expense of $12,500 is an average of $15,229 of additional net income before income tax expense. Assuming a combined federal and state income tax rate of 30%, the net income after income tax expense will average approximately $10,660 per year.
Treeline’s balance sheet will start with the new asset’s carrying amount (or the book value) of $100,000. The book value will decrease to $0 at the end of 8 years. In other words, the balance sheet amount will average about $50,000 per year during the 8-year period.
At this point, Treeline must choose one of the following calculations to estimate the accounting rate of return. (As with most “return” calculations, the numerator comes from the income statement and the denominator comes from the balance sheet.)
Average additional accounting net income before income tax expense ÷ the additional original investment:
Average additional accounting net income after income tax expense ÷ the additional original investment:
Average additional accounting net income before income tax expense ÷ the additional average investment:
Average additional accounting net income after income tax expense ÷ the additional average investment:
As you can see, the calculation Treeline chooses depends on (a) whether the company prefers to use before tax or after tax average accounting net income, and (b) whether it prefers to use the initial investment amount or the average investment amount.
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Cash Flows
The company’s cash flows are not the same as the accounting net income amounts that are based on accrual accounting. The following table shows the cash received or saved as positive amounts, and the cash that was paid out or lost as negative amounts (in parentheses).
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Nondiscounted Cash Flow Model
2. Payback
This method of evaluating business investments uses cash flows (not the accounting net income flows) to measure the amount of time it takes for a company to recoup its investment dollars.
There are two drawbacks to the payback model: (a) cash flows are not discounted for the time value of money, meaning that a dollar received three years from now has the same value as a dollar received in the current year, and (b) it fails to consider the profitability of the project in its entirety. For example, a project with a fast initial payback might not generate much profit over its life. Another project with a slow initial payback might be phenomenally profitable over its life because its profitability increases dramatically after the payback period.
Using the net cash flows before discounting in the table above, the payback period on the new machine for Treeline is 4.35 years:
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Discounted Cash Flow Models
3. Net Present Value
This method of evaluating business investments estimates all of the cash flowing in and out of a project. The estimated cash flows are then discounted to the present to reflect the time value of money.
This technique is referred to as a discounted cash flow model or a present value model because it brings all of the estimated future cash amounts back to the present time. Using our Treeline Manufacturing example, the estimated cash flows in Year 5 will be discounted more than the estimated cash flows in Year 1 because cash received in the future is less valuable than cash received today.
Present value tables and financial calculators allow us to discount future cash amounts to the present time. Below is a portion of a present value table. It shows the value today (the present value) of receiving (or paying) one dollar at various points in time when the time value of money is 12%:
From this table you can see that if the time value of money is 12%, receiving $1.00 in ten years is equivalent to receiving $0.32 today.
In the net present value model the company must specify the rate it will use for discounting the future cash flows. (The rate selected will likely be the minimum that the company needs to earn on the project after uncertainties, risks, and the company’s cost of capital are considered.) The combination of the present value of the cash inflows and the present value of the cash outflows is known as the net present value.
Assuming that Treeline chose to use a rate of 12%, let’s calculate the net present value of the relevant cash amounts for Treeline’s proposed purchase:
When the net present value is a positive amount, the project is earning more than the rate used to discount the cash flows. As you can see from the above table, Treeline’s proposed project is showing a positive net present value of $14,668. This means that the new machine will provide Treeline with $14,668 more in present value dollars than the minimum specified return of 12%.
A net present value of $0 would indicate that a project is expected to earn exactly the rate used to discount the future cash flows. If the net present value is a negative amount, the project will earn less than the rate used to discount the cash flows. (This doesn’t mean, however, that the project is showing a negative return—it could be the project is earning a return of 11% instead of the specified rate of 12%.)
4. Internal Rate of Return
This discounted cash flow model calculates the rate that will cause the net present value to equal zero. In other words, it answers the question, “What rate of return will the project earn over its life?” It is similar to the net present value method in that (a) all of the estimated cash flows over the entire life of the project are considered, and (b) the estimated cash flows are discounted to the present.
Since the internal rate of return model produces the rate that will discount all of the cash back to a net present value of exactly zero, you may need to try various rates (as shown in present value tables) until you find the exact rate that gives you zero. (You will save time by using a computer, financial calculator, or programmable calculator.)
As you can see below, Treeline finds that a rate of 16% will yield a net present value of $0:
Knowing that the project has an internal rate of return of 16% may be more useful to Treeline than knowing its net present value is $14,668. In fact, if this method is applied to all of its capital expenditure proposals, Treeline can easily rank the proposals according to profitability. For example, if Treeline decides to commit no more than $500,000 for nonemergency projects, it can start by funding those proposals which show the highest internal rate of return and work its way down the list until the entire $500,000 is committed.
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Another Application of a Present Value Calculation
A savvy company (or individual) will use the net present value method to help determine the amount it should spend to acquire another business. For example, assume that you wish to purchase Kirkland Co. You expect that the Kirkland Co. will generate positive net cash flows after tax of $15,000 per year for ten years, at which time you plan to liquidate or sell the company for $40,000 after taxes. To cover the risk associated with your investment in Kirkland Co. you need to earn 14%. With that in mind, what is the maximum amount you should pay today for Kirkland Co.?
The net present value method will give us the amount to be paid in order to earn 14%. The following table shows the required calculations:
If you purchase the Kirkland Co. for $89,100 you will earn exactly a 14% return if the cash flows occur as estimated. If you pay more than $89,100 you will earn less than a 14% return; a price of less than $89,100 means you will earn more than a 14% return.
To learn the rate that you will earn on a specific price, you can compute the internal rate of return. This is done by finding the rate that will discount the future cash amounts back to the price.
Where to Go From Here
We recommend taking our Practice Quiz next, and then continuing with the rest of our Evaluating Business Investments materials (see the full outline below).
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Things that are resources owned by a company and which have future economic value that can be measured and can be expressed in dollars. Examples include cash, investments, accounts receivable, inventory, supplies, land, buildings, equipment, and vehicles.
Assets are reported on the balance sheet usually at cost or lower. Assets are also part of the accounting equation: Assets = Liabilities + Owner’s (Stockholders’) Equity.
Some valuable items that cannot be measured and expressed in dollars include the company’s outstanding reputation, its customer base, the value of successful consumer brands, and its management team. As a result these items are not reported among the assets appearing on the balance sheet.
Amounts spent for property, plant and equipment.
One of the main financial statements. The balance sheet reports the assets, liabilities, and owner’s (stockholders’) equity at a specific point in time, such as December 31. The balance sheet is also referred to as the Statement of Financial Position.
One of the main financial statements (along with the balance sheet, the statement of cash flows, and the statement of stockholders’ equity). The income statement is also referred to as the profit and loss statement, P&L, statement of income, and the statement of operations. The income statement reports the revenues, gains, expenses, losses, net income and other totals for the period of time shown in the heading of the statement. If a company’s stock is publicly traded, earnings per share must appear on the face of the income statement.
The income statement account which contains a portion of the cost of plant and equipment that is being matched to the time interval shown in the heading of the income statement. (There is no depreciation expense for land.)
The formal planning for significant expenditures, such as property, plant and equipment.
The rate that will discount all cash flows to a net present value of zero.
The recognition that a dollar in the present is more valuable than a dollar in the future. Present-value calculators and present-value tables assist in converting future dollars to the present value in order to make a prudent decision.
Includes the main financial statements (income statement, balance sheet, statement of cash flows, statement of retained earnings, statement of stockholders’ equity) plus other financial information such as annual reports, press releases, etc.
Usually financial statements refer to the balance sheet, income statement, statement of cash flows, statement of retained earnings, and statement of stockholders’ equity.
The balance sheet reports information as of a date (a point in time). The income statement, statement of cash flows, statement of retained earnings, and the statement of stockholders’ equity report information for a period of time (or time interval) such as a year, quarter, or month.
The systematic allocation of the cost of an asset from the balance sheet to Depreciation Expense on the income statement over the useful life of the asset. (The depreciation journal entry includes a debit to Depreciation Expense and a credit to Accumulated Depreciation, a contra asset account). The purpose is to allocate the cost to expense in order to comply with the matching principle. It is not intended to be a valuation process. In other words, the amount allocated to expense is not indicative of the economic value being consumed. Similarly, the amount not yet allocated is not an indication of its current market value.
The accounting method under which revenues are recognized on the income statement when they are earned (rather than when the cash is received). The balance sheet is also affected at the time of the revenues by either an increase in Cash (if the service or sale was for cash), an increase in Accounts Receivable (if the service was performed on credit), or a decrease in Unearned Revenues (if the service was performed after the customer had paid in advance for the service).
Under the accrual basis of accounting, expenses are matched with revenues on the income statement when the expenses expire or title has transferred to the buyer, rather than at the time when expenses are paid. The balance sheet is also affected at the time of the expense by a decrease in Cash (if the expense was paid at the time the expense was incurred), an increase in Accounts Payable (if the expense will be paid in the future), or a decrease in Prepaid Expenses (if the expense was paid in advance).
This is the bottom line of the income statement. It is the mathematical result of revenues and gains minus the cost of goods sold and all expenses and losses (including income tax expense if the company is a regular corporation) provided the result is a positive amount. If the net amount is a negative amount, it is referred to as a net loss.
Also referred to as book value or carrying value; the cost of a plant asset minus the accumulated depreciation since the asset was acquired. This net amount is not an indication of the asset’s fair market value. Also used in reference to bonds payable: the face amount in Bonds Payable plus Premium on Bonds Payable or minus Discount on Bonds Payable and minus the unamortized issue costs.
The book value of an asset is the amount of cost in its asset account less the accumulated depreciation applicable to the asset. The book value of a company is the amount of owner’s or stockholders’ equity. The book value of bonds payable is the combination of the accounts Bonds Payable and Discount on Bonds Payable or the combination of Bonds Payable and Premium on Bonds Payable.
Future amounts that have been discounted to the present.
A corporation’s cost of capital is its weighted average after-tax cost of its debt, preferred stock, common stock, retained earnings, and other components of stockholders’ equity. The cost of capital is usually the minimum return that a company should accept on its investments.
For the past 52 years, Harold Averkamp (CPA, MBA) has
worked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online. He is the sole author of all the materials on AccountingCoach.com.
