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Capital budgeting. Duclos, Gerard George 1960

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CAPITAL BUDGETING by GERARD GEORGE DUCLOS B. Comm., U n i v e r s i t y of B r i t i s h Columbia, 1954 A THESIS SUBMITTED IN PARTIAL FULFILMENT OF THE REQUIREMENTS FOR THE DEGREE OF MASTER OF BUSINESS ADMINISTRATION i n the F a c u l t y of Commerce and Business A d m i n i s t r a t i o n We accept t h i s t h e s i s as conforming t c the r e q u i r e d standard THE UNIVERSITY OF BRITISH COLUMBIA A p r i l , 1960 In p r e s e n t i n g t h i s t h e s i s i n p a r t i a l f u l f i l m e n t of the requirements f o r an advanced degree at the U n i v e r s i t y o f B r i t i s h Columbia, I agree t h a t the L i b r a r y s h a l l make i t f r e e l y a v a i l a b l e f o r r e f e r e n c e and study. I f u r t h e r agree t h a t p e r m i s s i o n f o r e x t e n s i v e copying of t h i s t h e s i s f o r s c h o l a r l y purposes may be granted by the Head of my Department o r by h i s r e p r e s e n t a t i v e s . I t i s understood t h a t copying or p u b l i c a t i o n of t h i s t h e s i s f o r f i n a n c i a l g a i n s h a l l not be allowed without my w r i t t e n p e r m i s s i o n . DmmTMSSXXM: F a c u l t y of Commerce and Business A d m i n i s t r a t i o n The U n i v e r s i t y of B r i t i s h Columbia, Vancouver 8, Canada. Date A p r i l '/ , I960.  ABSTRACT C a p i t a l budgeting i s a form of s y s t -ematic planning of expenditure i n order to achieve sound investment programs which f u l f i l l manage-ment's t r u s t e e s h i p o b l i g a t i o n s ; the care and e f f e c -t i v e use of those funds entrusted to them by t h e i r shareholders and i n v e s t o r s . C a p i t a l budgeting i s the technique of ad m i n i s t e r i n g a c a p i t a l management program. I t i n -cludes many areas beginning w i t h the c r e a t i v e search f o r p r o f i t a b l e o p p o r t u n i t i e s and ending w i t h retirement and d i s p o s a l of a s s e t s . Between these two d e c i s i o n s l i e a host of others a l l of which are the subject of t h i s t h e s i s : long and short range c a p i t a l p l a n s , measurement of p r o j e c t worth, screen-ing and s e l e c t i o n of a l t e r n a t e proposals. The study has been developed through f o u r major areas: demand, supply, and cost of c a p i t a l , and e v a l u a t i o n of c a p i t a l expenditure proposals. This comprises a w e l l d e f i n e d concept of c a p i t a l budgeting about which much has already been w r i t t e n . I n a d d i t i o n to drawing t h i s m a t e r i a l together, C a p i t a l Budgeting seeks to evaluate the concept as a t o o l of p r a c t i c a l b u s i n e s s . How v a l u a b l e i s t h i s ap-proach to p r a c t i c i n g management? While i t seems l o g i c a l to expect that much use would be made of the concept of c a p i t a l budgeting; i n f a c t , b u s i n e s s has found some l i m i t a t i o n s i n i t s use, p a r t i c u l a r l y w i t h the r e t u r n on investment c r i t e r i o n . In f a c t , s u b s t a n t i a l l y l e s s use of t h i s approach i s being made than might have been expected i n view of the e n t h u s i a s t i c promotion i t has r e c e i v e d i n the a c c o u n t i n g l i t e r a t u r e of r e c e n t y e a r s . C a p i t a l budgeting procedures are no panacea f o r management's problems, nor are they a s u b s t i t u t e f o r good judgment. A l l f a c t o r s i n f l u e n c -i n g a d e c i s i o n cannot be reduced to q u a n t i t a t i v e formulae and any r e l i a n c e on such seemingly meaning-f u l a r i t h m e t i c m a n i p u l a t i o n s to the e x c l u s i o n of the e x e r c i s e of sound judgment w i l l l e a d to s e r i o u s problems. In p a r t i c u l a r the r e t u r n on investment c r i t e r i o n as an a i d to measurement and e v a l u a t i o n of c a p i t a l expenditure d e c i s i o n s has an important and v a l u a b l e c o n t r i b u t i o n to make, but must be viewed i n the p e r s p e c t i v e of the t o t a l of a l l f a c t o r s to be - i v -considered. Those who c l a i m that such a c r i t e r i o n oan embrace a l l f a c t o r s , that i s , meet the t e s t of a l l - i n c l u s i v e n e s s , are misled and cannot but be d i s i l l u s i o n e d at the shortcomings of such an attempted e v a l u a t i o n . TABLE OP CONTENTS INTRODUCTION 1 CHAPTER I. A CAPITAL MANAGEMENT PROGRAM 6 I I . THE DEMAND POR CAPITAL 11 I I I . THE SUPPLY OP CAPITAL . 15 IV. THE COST OP CAPITAL. 25 7. MEASUREMENT AND EVALUATION 30 V I . POSTPONABILITY AND PAYBACK AS MEASUREMENT CRITERIA .... 35 V I I . THE RETURN ON INVESTMENT CONCEPT 39 V I I I . THE PRACTICAL APPLICATION OP DISCOUNT METHODS 43 IX. A SURVEY OP PRACTICE 65 X. EVALUATION OP THE SURVEY...... 81 XI. CONCLUSIONS 91 BIBLIOGRAPHY 93 APPENDIX A 101 APPENDIX B 103 INTRODUCTION C a p i t a l budgeting i s an e x e r c i s e i n economics. I t i s that k i n d of s y s t e m a t i c programming r e q u i r e d f o r sound investment of s t o c k h o l d e r s ' money. P l a n n i n g and con-t r o l of c a p i t a l expenditure i s the b a s i c management f u n c t i o n because management i s employed to a d m i n i s t e r s t o c k h o l d e r s ' funds and to maximize t h e i r e a r n i n g power. In a broad sense, t h e r e f o r e , p r o d u c t i o n , market-i n g , p e r s o n n e l and a c c o u n t i n g can be viewed as s u b s i d i a r y problems to a d m i n i s t e r i n g management's t r u s t e e s h i p over c a p i t a l . U n t i l r e c e n t l y , l i t t l e a t t e n t i o n has been p a i d to c a p i t a l budgeting, per se, e s p e c i a l l y by economists, and there e x i s t s a wide g u l f of unknown water between economic theory of investment and management's d e c i s i o n to spend.1 C a p i t a l expenditure i s the b a s i c i n -g r e d i e n t of c a p i t a l budgeting. T h i s term as used i n t h i s study w i l l i n c l u d e items which do not f a l l w i t h i n the accountant's d e f i n i t i o n of c a p i t a l . Por purposes of e v a l u a t i o n one must thin k of cap-i t a l expenditure i n an economic sense. The e s s e n t i a l c r i t e r i o n i s the r a t e of turnover i n t o cash. In p r a c t i c e some items of a minute nature 1 J o e l Dean, C a p i t a l Budgeting, (New York, C o l -umbia U n i v e r s i t y P r e s s , 1951), pp. 1-3. - 2 -must be excluded from c o n s i d e r a t i o n r e g a r d -l e s s of t h e i r r a t e of turnover i n t o cash. Most of the items c l a s s i f i e d as I'Current A s s e t s " on a standard balance sheet w i l l a l s o be ex-cluded. Although i n v o l v i n g a cash o u t l a y , t h e i r turnover p e r i o d i s u s u a l l y s h o r t enough and con-t r o l over t h a t turnover s u f f i c i e n t enough to make them a d j u s t a b l e i n a r e a s o n a b l y short time. I t i s the major expenditure which t i e s up c a p i t a l i n f l e x i b l y f o r long p e r i o d s that m e r i t s c o n s i d e r a -t i o n f o r c a p i t a l budgeting. Wise c a p i t a l budget d e c i s i o n s are of the utmost importance to both the n a t i o n and the company making them; to the na-t i o n because they g i v e i t a modern, e f f i c i e n t , and complete i n d u s t r i a l p l a n t ; to the company because they h e l p i t keep i t s p l a c e i n our dynamic economy.^ This i n q u i r y i n c l u d e s the f o u r major areas of c o n s i d e r a t i o n that normally comprise the c o n s t r u c t i o n of a c a p i t a l budget. The f i r s t of these i s the demand f o r c a p i t a l , i n v o l v i n g a survey of the need f o r c a p i t a l expenditure and a survey of p r o f i t a b l e o p p o r t u n i t i e s f o r i n v e s t s 2 J . A. Griswold, "More For Your C a p i t a l D o l l a r " , C o n t r o l l e r , October, 1957, p. 480. - 3 -ment. This i s the phase that i s u s u a l l y regarded as "preparing the budget" i n many companies. In f a c t , as we s h a l l see, t h i s i s only the f i r s t phase and a f a i r l y small part of the t o t a l r e -quirements of a c a p i t a l budget. I f the need i s present, the next l o g -i c a l c o n s i d e r a t i o n i s the source of funds to f i l l that need, i . e . the supply of c a p i t a l . This con-s i d e r a t i o n can be e a s i l y broken down i n t o two major p a r t s . How much of the needed supply can be gen-erated from w i t h i n the company? I t must be noted that t h i s supply i s cash and may d i f f e r from the company's p r o f i t . The second part i s how much of the supply can or should be obtained from outside f i n a n c i n g . The d e c i s i o n must be made whether out-side f i n a n c i n g i s to be considered at a l l . I f money i s to be r a i s e d from outside sources what form of f i n a n c i n g w i l l be used; debt f i n a n c i n g or equity f i n a n c i n g ? To answer the questions of supply through i n t e r n a l or e x t e r n a l f i n a n c i n g , the cost of c a p i t a l must be examined. Current market condi-t i o n s and the cost of the v a r i o u s forms of outside - 4 f i n a n c i n g must be analyzed to determine the p r a c t i c a b i l i t y of the proposed f i n a n c i n g . The cost of c a p i t a l a l s o i n t r o d u c e s a q u e s t i o n of the timing of investments which must be i n t e r -r e l a t e d to the need or demand f o r c a p i t a l . I f i t i s p o s s i b l e to o b t a i n a l l the i n f o r m a t i o n needed p e r t a i n i n g to the demand, supply and c o s t o f c a p i t a l , how s h a l l a d e c i s i o n be reached, that i s , a c a p i t a l budget c o n s t r u c t -ed? Some form or standard of e v a l u a t i o n i s r e q u i r e d . P o s s i b l e standards w i l l form the f i n a l or f o u r t h s e c t i o n of t h i s paper. There are s e v e r a l forms of q u a n t i t a t i v e measurement that have been proposed and used. These w i l l be d i s -cussed i n Chapter YI and V I I . Some expenditure p r o p o s a l s do not l e n d themselves t o q u a n t i t a t i v e e v a l u a t i o n however, and as a r e s u l t the task of d e c i d i n g among a l t e r n a t i v e s becomes a very d i f f i c u l t one f o r the a d m i n i s t r a t o r . The f i n a l element of the measurement phase, the e s t a b l i s h -ment of a s c a l e o r p r i o r i t y of investments (with the attendant f a c t o r s of r a t i o n i n g of c a p i t a l and r e j e c t i o n of p r o p o s a l s that cannot be j u s t i f i e d ) - 5 -r e s u l t s from the comparison of the i n d i v i d -u a l l y e v a l u a t e d p r o p o s a l s . CHAPTER I A CAPITAL MANAGEMENT PROGRAM C a p i t a l budgeting and the methodology surrounding i t i s a s u b j e c t that has come i n t o f a s h i o n i n recent y e a r s . I t has r e c e i v e d a great d e a l of t h e o r e t i c a l treatment and has ac q u i r e d as a r e s u l t , an aura of mys t i c i s m that obscures i t s value to the p r a c t i c a l businessman. C a p i t a l budgeting i s concerned w i t h d e s i g n i n g a systematic program f o r i n v e s t i n g funds. I t i s o r d i n a r i l y thought of as p e r t a i n i n g to durable p l a n t but embraces muoh more. I t can and should be c o n s i d e r e d when p l a n n i n g a long term adver-t i s i n g program, b u i l d i n g a marketing o r g a n i z a t i o n , s e t t i n g up a management t r a i n i n g program and a good many other investment d e c i s i o n s . In many cases the circumstances do not l e n d themselves to q u a n t i t a t i v e e x p r e s s i o n . C a p i t a l budgeting, although a p p l i e d , i s much l e s s o b j e c t i v e than i n the case of measurable committments where r e t u r n s can be expressed q u a n t i t a t i v e l y . - 7 -One should not be m i s l e d i n t o t h i n k i n g that the t o o l s and t h e o r i e s r e l a t e d t o c a p i t a l budgeting are new. General Motors and Bupont f o r m a l i z e d the Return on Investment concept as a b a s i c i n g r e d i e n t of c a p i t a l budgeting t h i r t y - f i v e y e a r s ago. What i s r e l a t i v e l y new i s the emphasis being p l a c e d on these t o o l s as a g e n e r a l manage-ment a i d to investment d e o i s i o n s . In h i s a r t i c l e "Measuring the Product-i v i t y of C a p i t a l " 3 , J o e l Dean d e f i n e s ten compon-ents of a c a p i t a l management program which sum-marize the scope of the whole problem. In t h i s d i s c u s s i o n items 2, 3, 4, and 5 w i l l be emphasized but they must be c o n s i d e r e d i n the p e r s p e c t i v e of a t o t a l program. 1. C r e a t i v e search f o r p r o f i t a b l e o p p o r t u n i t i e s . The f i r s t stage i s conception of the u n d e r l y i n g p r o f i t - m a k i n g i d e a which i s to be embodied i n the c a p i t a l f a c i l i t y . T urning up p r o f i t a b l e o p p o r t u n i t i e s f o r i n v e s t i n g company's c a p i t a l i s i n p a r t a 3 J o e l Dean, "Measuring the P r o d u c t i v i t y of C a p i t a l " , Harvard Business Review, January, 1954, p. 122. - 8 -by-product of good management. But t h i s cannot be depended upon to provide the p l e t h o r a of e n t i c i n g c a p i t a l pro-p o s a l s that c o n s t i t u t e the raw m a t e r i a l f o r good management of c a p i t a l expen-d i t u r e s . Inadvertant o p p o r t u n i t i e s should be supplemented by an a c t i v e pro-gram of seeking out and i n v e s t i g a t i n g such o p p o r t u n i t i e s . 2. Long range c a p i t a l p l a n s . To provide c o n s i s -tent benoh marks f o r proposals o r i g i n -a t i n g i n a l l p a r t s of the o r g a n i z a t i o n , i t i s necessary to have some k i n d of p l a n sketched out f o r the f u t u r e . In-d i v i d u a l proposals should conform to t h i s broad planning. 3. Short range c a p i t a l budget. L i s t i n g of a p r o j e c t i n a y e a r l y c a p i t a l budget i n -d i c a t e s only that i t i s approved as being worthy of d e t a i l e d study f o r that year. 4. Measurement of p r o j e c t worth. This i s the stage where e v a l u a t i o n c r i t e r i a are ap-p l i e d to j u s t i f y the p r o j e c t by f i n a n c i a l - 9 -and economic a n a l y s i s of i t s i n v e s t -ment worth to the company. 5. Screening and s e l e c t i o n . The i n d i v i d u a l p r o j e c t must be compared w i t h other r i v a l p r o j e c t s i n the l i g h t of cash a v a i l a b l e , cost of c a p i t a l , and the a t t r a c t i v e n e s s of a l t e r n a t i v e i n v e s t -ments. 6. C o n t r o l of a u t h o r i z e d o u t l a y s . T h i s phase i n v o l v e s a system of c o n t r o l and com-p a r i s o n to the a u t h o r i z e d budget. 7. Post mortems. Reassessment and r e a p p r a i s a l of both cost and earnings should be c a r r i e d out a f t e r the p r o j e c t has been pl a c e d i n o p e r a t i o n . 8. Retirement and d i s p o s a l . Management's r e -s p o n s i b i l i t y f o r a p r o j e c t ends only when the a s s e t has been d i s p o s e d of and a s u i t a b l e f u t u r e course of a c t i o n planned. 9. Forms and procedures. Paper work, although a nuisance, i s necessary to a smooth o p e r a t i o n . - 10 -10. Economics of c a p i t a l budgeting. Wise d e c i s i o n s i n t h i s v i t a l l y important f i e l d of management can only be made i f those r e s p o n s i b l e keep themselves as up-to-date as p o s s i b l e i n current economic t h i n k i n g . Furthermore the accuracy of the answers are only as accurate as the f a c t s on which they are based. CHAPTER I I THE DEMAND PGR CAPITAL In order to determine the demand f o r c a p i t a l the p o t e n t i a l needs of a company must f i r s t be surveyed. T h i s i s the u s u a l s t a r t i n g p o i n t f o r c o m p i l i n g a c a p i t a l budget. At per-i o d i c i n t e r v a l s a company w i l l canvass a l l i t s departments or d i v i s i o n s f o r expenditure pro-p o s a l s . T h i s i s most o f t e n done once a year but may be done f o r much l o n g e r p e r i o d s w i t h r e -assessments and reviews being made at s h o r t e r i n t e r v a l s . In r e q u e s t i n g p r o p o s a l s management may d e f i n e g e n e r a l l i m i t s or s p e c i f y the char-a c t e r of investment that w i l l be c o n s i d e r e d most f a v o u r a b l y but u s u a l l y few l i m i t a t i o n s are im-posed, the s e l e c t i o n or e l i m i n a t i o n p r o c e s s being d e f e r r e d u n t i l a l a t e r stage. At t h i s p o i n t a c o n f l i c t of purpose o f t e n emerges. I t r e v o l v e s around the term "need". Some expenditures may have a s u b j e c t i v e need but the amount cannot be j u s t i f i e d on the b a s i s of - 12 -q u a n t i t a t i v e e v a l u a t i o n . I t i s o f t e n s a i d that suoh an expenditure i s j u s t i f i e d on the b a s i s of making the department or the person i n question more e f f e c t i v e . E f f e c t i v e n e s s becomes very d i f f i c u l t to measure. The c o n s i d e r a t i o n of e f f e c t i v e n e s s often occurs i n connection w i t h s e r v i c e equipment or t r a i n i n g plans which may inv o l v e s u b s t a n t i a l expenditures. Immediately i t may be seen that t h i s process of c a p i t a l budgeting cannot be reduced to mechanics. I t must eontain a s u b s t a n t i a l element of judgment. This aspect w i l l be r e f e r r e d to i n more d e t a i l l a t e r i n the d i s c u s s i o n of measure-ment and e v a l u a t i o n . Many companies take the p o s i t i o n that once a major u n i t has been approved the a u x i l i a r y or s e r v i c e equipment f o r the p r o j e c t i s a l l a u t o m a t i c a l l y approved provided the expenr d i t u r e s are w i t h i n the t o t a l amount a l l o c a t e d f o r the p r o j e c t . In f a c t , i t would appear that some d i v i d i n g l i n e must be e s t a b l i s h e d i f the budget committee i s not to be burdened w i t h minute items a f f e c t i n g very l i t t l e the c a p i t a l budget as a whole. There i s another aspect to the term - 13 -"need". This i s best r e f e r r e d to by s u b s t i t u t i n g the term "demand". Demand f o r c a p i t a l w i l l a r i s e i n two areas. One i s i n the nature of expansion or replacement of major u n i t s of a company's e n t e r p r i s e . An example of t h i s k i n d of demand would be the a d d i t i o n of a new production l i n e to a manufacturer's e x i s t i n g p l a n t . Another area i s that of investment of funds i n p r o j e c t s not d i r e c t -l y connected w i t h the business of the company; f o r example, long term investment of funds i n a land and i n d u s t r i a l development by a company p r i -m a r i l y engaged i n the generation and sale of e l e c t r i c i t y . I n these cases the e v a l u a t i o n of demand can become f a r more o b j e c t i v e and qua-n t i t a t i v e standards can be more r i g i d l y a p p l i e d . A p p l i c a t i o n of these standards w i l l be d e a l t w i t h f u r t h e r i n Chapters V, V I , and V I I . Returning to the survey of a company's demand f o r c a p i t a l , the next step i s u s u a l l y a ma r s h a l l i n g of a l l the i n d i v i d u a l needs and the c o n s t r u c t i o n of a budget proposal. In order that t h i s may be done, i n d i v i d u a l proposals w i l l have to be prepared i n s u f f i c i e n t d e t a i l to a r r i v e at - 14 -a tentative total cost and length of time construct or complete. CHAPTER I I I THE SUPPLY OP CAPITAL Once the demand f o r c a p i t a l i s known, the next c o n s i d e r a t i o n must be from what source the funds can be obtained or i f they can be ob-t a i n e d at a l l . There are two main sources that may be c o n s i d e r e d . These are u s u a l l y c a l l e d i n -t e r n a l and e x t e r n a l sources. By i n t e r n a l sources, i t i s meant those funds generated by the company i n the course of i t s business a c t i v i t y . I t i s commonly s t a t e d that these funds a r i s e out of d e p r e c i a t i o n and r e t a i n e d e a r n i n g s . T h i s statement i s m i s l e a d i n g because d e p r e c i a t i o n i s not a cash expenditure and no funds are i n v o l v e d i n the d e p r e c i a t i o n charge. A more ac c u r a t e view of i n t e r n a l supply of funds w i l l r e s u l t i f the cash flow i s examined. The funds generated by a business are the cash r e s i d u e a f t e r a l l cash disbursements are deducted from a l l cash revenues r e c e i v e d i n the course of - 16 -a p e r i o d of o p e r a t i o n . ^ A secondary i n t e r n a l source a r i s e s from the sale of a s s e t s such as property or s e c u r i t i e s . Temporary funds can a l s o be made a v a i l a b l e through the r e d u c t i o n of working c a p i t a l . However, t h i s i s not a true generation of funds, as working c a p i t a l merely represents l i q u i d assets 1 which may be put to use as short term investment or r e t a i n e d as cash (the most l i q u i d asset) f o r ' the purpose of the day to day operations of the business. The net funds a v a i l a b l e from i n t e r n a l souroes, are that p o r t i o n of the t o t a l cash generated that i s not disbursed i n the form of cash dividends to the shareholders. The amount a v a i l a b l e from t h i s source w i l l depend on three f a c t o r s : 1) the a b i l i t y of the business to generate cash, 2) e x i s t i n g committments f o r use of cash, such as s i n k i n g fund requirements, 3) and the dividend p o l i c y . ^ Many companies finance a l l expansion by r e s t r i c t i n g dividends and plowing back a l l a v a i l a b l e funds, not other-4 See Appendix B f o r an example i l l u s t r a t i n g t h i s view. 5 See Appendix B f o r example. - 17 -wise committed, i n t o expansion and investment. T h i s p r a c t i c e has made p o s s i b l e much of the growth and r a p i d p r o g r e s s of many of our I n d u s t r i e s d u r i n g the l a s t f i f t y y e a r s . However, the p r a o t i c e might not be j u s t i f i e d , as i t denies the s h a r e h o l d e r (owner) the b a s i c r i g h t of making h i s own d e c i s i o n as to the merit of a p a r t i c u l a r investment. Management and the Board of D i r e c -t o r s are charged w i t h the r e s p o n s i b i l i t y of t r u s t e e s h i p of the funds i n v e s t e d i n the e n t e r -p r i s e . They have an o b l i g a t i o n to use these funds w i s e l y and t o ensure t h a t a r e t u r n , equal-i n g the cost o f money f o r t h a t undertaking, i s earned f o r the s h a r e h o l d e r s . The use to which that r e t u r n i s put i s not w i t h i n management's or the d i r e c t o r a t e ' s r e s p o n s i b i l i t y . T h i s d e c i s i o n should be l e f t to the sh a r e h o l d e r s . One way of accomplishing t h i s i s to d i s b u r s e e a r n i n g s i n the form of d i v i d e n d s to the sh a r e h o l d e r s . These sh a r e h o l d e r s may then decide to what use the funds s h a l l be put. Management and the d i r e c t o r a t e would then be r e q u i r e d to s u b s t a n t i a t e t h e i r case f o r expansion through reinvestment, i n the same 18 manner as i s necessary f o r the s o l i c i t a t i o n of e x t e r n a l funds f o r investment. S.P. Dobrovolsky^ p o i n t s out that a p r a o t i c e of paying out a h i g h e r p r o p o r t i o n of earnings i n the form of d i v i d e n d s would reduce the funds a v a i l a b l e f o r investment. One reason f o r t h i s i s that the r e c i p i e n t s may choose to spend some of these funds f o r c u r r e n t purposes, r a t h e r than saving them f o r reinvestment. A second argument i s that under pres e n t tax law, d i v i d e n d s are s u b j e c t to income tax, thus r e -du c i n g the funds a v a i l a b l e f o r reinvestment through a f o r c e d c o n t r i b u t i o n to the government. The second argument i s of s i g n i f i c a n c e . To make the p r o p o s a l o u t l i n e d above of p r a c t i c a l m e r i t would r e q u i r e a change i n e x i s t i n g tax l e g i s l a t i o n . However i n theory there i s l i t t l e defence f o r the f i r s t argument even i f the f a c t s of i t are acknowl-eged. I f a shareholder wishes to spend the r e t u r n s from h i s investment i n s t e a d of r e i n v e s t i n g them, . i t should be h i s unquestionable r i g h t to do so. I t i s not f o r management or the d i r e c t o r a t e to say what 6 S.P. Dobrovolsky, "Economics of Corporate In-t e r n a l and E x t e r n a l F i n a n c i n g " , J o u r n a l of F i n -ance , March, 1958, pp. 35-46. - 19 -i s the b e t t e r choice f o r the shareholder. They may advise but the d e c i s i o n should remain w i t h the r i g h t f u l owner of the funds. I f the owner of the funds does, i n f a c t , spend the dividend f o r current consumptions i n -stead of r e i n v e s t i n g , there i s no reason to con-clude that the t o t a l funds a v a i l a b l e f o r i n v e s t -ment are decreased. The funds expended enter the money stream and are returned to the p o t e n t i a l savings of another sector of the economy. The funds a v a i l a b l e f o r investment must be viewed as a part of the t o t a l money supply and not as a separate pool of funds. I t i s recognized and acknowledged that our modern business s o c i e t y i n v o l v e s large d i -v e r s i f i e d ownership; absentee owners who appear to have l i t t l e i n t e r e s t i n t a k i n g part i n the conduct of a f f a i r s that a f f e c t t h e i r investment. However, i t may be suggested that i f the freedom of choice of investment were returned to i t s r i g h t -f u l h o l d e r , the owner (shareholder) would become a more aware, and a more s i g n i f i c a n t i n f l u e n c e i n the d i s p o s i t i o n of corporate savings. - S G -On the other hand, W i l l i a m C. Hood presents a conclusive a n a l y s i s on the m e r i t s of f i n a n c i n g through business saving, that i s , through the funds r e s u l t i n g from r e t a i n e d earn-ings and p r o v i s i o n f o r d e p r e c i a t i o n . 7 He acknowledges that the p r o v i s i o n of funds f o r c a p i t a l expansion from r e t a i n e d earnings r e s u l t s i n a circumvention of the c a p i t a l market but p o i n t s out that t h i s i s not u n d e s i r a b l e , nor does i t produce a m i s a l l o c a t i o n of funds. In the f i r s t p l a c e , i n many cases, p r o j e c t s "are only p a r t l y financed i n t h i s way, the balance of funds r e q u i r e d being obtained from new i s s u e s i n the c a p i t a l market". 8 Hence these p r o j e c t s are appraised by the i n v e s t o r s at l a r g e . In the second p l a c e , p r o j e c t s financed wholly from r e -tained earnings r e c e i v e a market t e s t through the workings of the economy at large of which the c a p i t a l market i s a p a r t . The u l t i m a t e t e s t of any undertaking i s i t s p r o f i t a b i l i t y and without p r o f i t s the f i r m w i l l not survive long. 7 W i l l i a m 0. Hood, f i n a n c i n g of Economic Act- i v i t y i n Canada, Royal Commission on Canada's Economic Prospects, pp. E67-274. 8 I b i d . , p. 23. - 21 -The Important q u e s t i o n i s t h i s : "does the use of business s a v i n g by the savers themselves n e c e s s a r i l y i n c r e a s e the p o s s i b i l i t y of m i s a l -l o o a t i o n of r e s o u r c e s ? " 9 Rather, to discourage r e t e n t i o n of earnings by these savers, p a r t i c u l a r l y i n the case of s m a l l f i r m s , would produce a g r e a t -e r m i s a l l o c a t i o n of funds because the v e r y e x i s t -ence of these f i r m s i s dependant on p r o f i t s and i f p r o f i t a b l e , they must be meeting the u l t i m a t e t e s t of the economy as a whole. To deny t h i s t e s t i s to deny the r i g h t of these f i r m s to e x i s t a t a l l . Another argument i s t h a t , i n f a c t , the market (the i n v e s t o r s ) do not s u b j e c t investment p r o p o s a l s to any g r e a t e r c r i t i c a l a n a l y s i s than do the companies themselves. Hence the judgment of the semi-informed i n v e s t o r i s a no b e t t e r e v a l u a t i o n than the e v a l u a t i o n of the f i r m p r o p osing the i n -vestment and cannot be s a i d to r e s u l t i n a b e t t e r a l l o c a t i o n of funds.1® T h i r d l y , the p r o p o r t i o n of n o n - i n s t i t u -t i o n a l h o l d e r s of corporate s e c u r i t i e s i s exoeed-9 I b i d . , p. 271. 1G T b l d . , p. 272. - 22 -i n g l y small and the d e c i s i o n s as to a l l o c a t i o n of funds are thus i n l a r g e p a r t , merely i n t e r -company d e c i s i o n s . Through e x t e r n a l f i n a n c i n g one i s merely p l a c i n g the a p p r a i s a l d e c i s i o n i n another i n s t i t u t i o n a l h a n d . 1 1 T h e r e f o r e , w h ile i t may be s a i d t h a t , i n theory, r e t e n t i o n of e a r n i n g s f o r expansion i s not j u s t i f i e d , the p r a c t i c a l e f f e c t of such an argument has l i t t l e m e r i t . There i s no con-c l u s i v e evidence to suggest that the m u l t i p l i -c i t y of d e c i s i o n r e s u l t i n g from the a p p r a i s a l by the c a p i t a l market of investment p r o p o s a l s would r e s u l t i n any b e t t e r a l l o c a t i o n or u t i l i z a t i o n of f u n d s . 1 2 Having co n s i d e r e d i n t e r n a l sources of c a p i t a l and some of the f a c t o r s surrounding t h e i r use, the next c o n s i d e r a t i o n w i l l be the forms of e x t e r n a l f i n a n c i n g . There are two ways to accomplish ex-t e r n a l f i n a n c i n g : through i n c r e a s e d e q u i t y or by long or short term debt f i n a n c i n g . To f i n -ance through e q u i t y o f f e r i n g s i n v o l v e s going to 11 I b i d . , p. 273. 12 I b i d . , p. 267-274. - 23 -the present shareholders and/or prospective investors with an o f f e r i n g of common or pre-ferred shares. By long term debt financing i s meant the r a i s i n g of funds through bond or debenture issues. The form of financing chosen w i l l depend on many fa c t o r s . The most important of these i n assessing the p r o f i t -a b i l i t y of a proposed undertaking, i s the cost of c a p i t a l . Before examining the cost of c a p i t a l , i t must be recognized that, although th i s w i l l be a very important fa c t o r , and i n most instances a measurable one, there are several other factors which may influence a decision as to the type of external financing. For example, i t might be determined that a Bommon stock o f f e r i n g might be the best form considering cost of c a p i t a l , condition of the market, present c a p i t a l i z a t i o n structure, e t c . On the other hand, i f the organization i s at present closely held and controlled, there may be a great reluctance to l e t any portion of share control and ownership pass to other hands. In such circumstances the firm may well decide - E4 7 . to use a form of financing that i s le s s desirable from the standpoint of objective considerations but which s a t i s f i e s better some subjective considerations. CHAPTER 17 THE COST OP CAPITAL Before examining the co s t of c a p i t a l ' s r e l a t i o n s h i p to the forms of f i n a n c i n g and the c a p i t a l budget p i c t u r e as a whole, we should f i r s t c o n s i d e r what i s meant by t h i s term " c o s t of c a p i t a l " . The compensation f o r the use of money i s u s u a l l y c a l l e d i n t e r e s t . I n t e r e s t i s revenue to the le n d e r and cost to the borrower. I t i s p a i d on the p r i n c i p a l amount borrowed ( c a p i t a l ) , hence our phrase " c o s t of c a p i t a l " . The r a t e of i n t e r e s t i s based on both the amount of money and the l e n g t h of time i n v o l v e d . Por t h i s purpose the p r i n c i p l e of compound i n t e r e s t has been de-ve l o p e d . A b r i e f look at the money market w i l l i n d i c a t e that there are many r a t e s of i n t e r e s t i n use. There i s an i n t e r e s t r a t e , a time p e r i o d , and a method of repayment to s u i t almost any l e n d e r ' s o r borrower's requirements. - 26 -Why are there d i f f e r e n t rates of interest? It i s generally regarded that the interest rate i s made up of several components. The f i r s t of these i s the amount of money, and the second i s the length of time before repay-ment i s made. The t h i r d factor i s what i s usual-l y c a l l e d " r i s k " . The v a r i a t i o n i n the interest rate w i l l usually be i n proportion to the amount of money and the length of time involved. The r i s k f a c t o r i s a subjective assessment of the p r o b a b i l i t y that the future repayment w i l l occur at the time and i n the amount promised. This can be more readi l y seen i f one looks at some examples. Interest rates on govern-ment bonds are generally low because the backing of a l l the resources of the government reduces the r i s k to a very n e g l i g i b l e proportion. The interest rate on mortgages w i l l be higher as the r i s k of default i s greater. Another comparison i s that between bonds and common stocks. The prospect of dividends on common shares i s less cer t a i n than the payment of the interest on the bonds; hence the y i e l d i s generally higher than * 27 -that f o r bonds. The y i e l d w i l l a l s o vary w i t h a great number of other f a c t o r s i n c l u d i n g the nature of the i n d u s t r y i t s e l f , the c a l i b r e of management and i t s h i s t o r y ; but b a s i c a l l y i t i s a - f u n c t i o n of time, l i n k i n g present value w i t h f u t u r e expecta-t i o n s through the compound i n t e r e s t p r i n c i p l e . The cost of c a p i t a l w i l l be a very im-portant determinant i n the a c c e p t a b i l i t y of the proposed use of that c a p i t a l . When cons i d e r i n g i n t e r n a l sources of c a p i t a l , the cost becomes a h i g h l y t h e o r e t i c a l concept. In a p r a c t i c a l sense the company has the funds and i t costs them no-t h i n g i n the way of a cash outlay to r e i n v e s t or "plow-back". However, over the long term there i s some evidence to suggest that a heavy emphasis on plow-back w i l l depress the p r i c e of the com-pany's stock i n the market and thereby increase the company's cost of c a p i t a l f o r f u r t h e r i s s u e s of stock.!3 j n a t h e o r e t i c a l sense there i s a cost of plowed-back earnings. This cost i s the amount that such funds as are plowed-back could earn i f invested elsewhere. 13 S.P. Dobrovolsky, op. c i t . , p. 38. - 28 -When con s i d e r i n g e x t e r n a l sources of f i n a n c i n g , cost of c a p i t a l becomes a very r e a l , a c t u a l , cash commitment. , The cost of c a p i t a l i n the case of an equity issue i s that r a t e of r e t u r n demanded by the i n v e s t o r s to induce them to r e -lease the funds. For example, i f the i n v e s t o r s are r e q u i r i n g a ten percent r e t u r n and the com-pany's dividend i s c u r r e n t l y three d o l l a r s per share, the highest p r i c e an i n v e s t o r w i l l pay w i l l be t h i r t y d o l l a r s per share. Furthermore, there w i l l be no point i n going to the market w i t h an e q u i t y issue i f the proposed investment of the funds r a i s e d by such an issue w i l l not y i e l d more than the ten percent s t a t e d . I f the payout through dividends i s l e s s than 100% of earnings, which i t normally i s , the minimum acceptable y i e l d from the investment w i l l have to be even g r e a t e r . For example i f the d i v i d e n d payout i s s i x t y percent of net earnings, the minimum acceptable y i e l d to make the i n v e s t -ment proposal worthwhile w i l l have to be greater than s i x t e e n and two t h i r d s percent. The cost of c a p i t a l i n the case of a bond or debenture issue i s the e f f e c t i v e y i e l d - 89 -of the bond at the time of sale. This should not be confused with the coupon rate, as the sale price may not be the same as the face value of the bond. The cost of bond or debenture c a p i t a l i s the coupon rate of the issue plus any amortization of discount or minus any amortization of premium. It has been found that the cost of debt financing i s usually less than equity financing. Therefore, presumably the earnings of a project could be less under the former and s t i l l be acceptable from the firm's point of view, other factors being equal.^ 4 14 D. Bodenham, "On the Problem of Capital Budgeting", Journal of Finance, December, 1959, p. 476. CHAPTER V •MEASUREMENT AND EVALUATION Having compiled i n f o r m a t i o n and obtained the needed data on demand, supply and cost of c a p i t a l , the i n t e r r e l a t i o n s h i p of these three must then be c o n s i d e r e d to a r r i v e at a d e c i s i o n as to the m e r i t s of the proposed c a p i t a l e x p e n diture. Here the s u b j e c t i v e and o b j e c t i v e c r i t e r i a a v a i l a b l e w i l l be a p p l i e d to t e s t the a c c e p t a b i l i t y of the expenditure p r o p o s a l and, i f a p p r o v a l i s g i v e n , e s t a b l i s h a p l a n f o r ex-e c u t i o n of the p r o j e c t . There are three standards that are most o f t e n a p p l i e d to the problem of measurement and e v a l u a t i o n . They are p o s t p o n a b i l i t y , payback, and p r o f i t a b i l i t y or r a t e of r e t u r n on investment. Each of them w i l l be d i s c u s s e d i n t u r n , and l a t e r an attempt to a s s e s s t h e i r use i n terras of a c t u a l a p p l i c a t i o n w i l l be made. In order to have a y a r d s t i c k a g a i n s t which to e v a l u a t e the v a r i o u s approaches to - 31 -measurement of c a p i t a l expenditure p r o p o s a l s , some c r i t e r i a w i l l be enumerated. The r e q u i r e -ments of a good y a r d s t i c k f o r measuring i n v e s t -ment p r o p o s a l s , are suggested by J o e l Dean i n h i s a r t i c l e , " P r o f i t a b i l i t y I n d i c e s f o r C a p i t a l Investment":"^ 1. Accuracy - measures p r o d u c t i v i t y of c a p i t a l c o r r e c t l y . 2. I n c l u s i v e n e s s - summarizes p r o j e c t m e r i t s i n a s i n g l e f i g u r e . 3. R e a l i s m - l o o k s only at what happens to what i s important - cash. 4. V e r s a t i l i t y - makes d i f f e r e n t types of p r o j e c t s comparable. 5. P a r i m u t u e l i t y - r e f l e c t s c o r r e c t l y the b e t t i n g odds on g e t t i n g the estimated e a r n i n g s . 6. S i m p l i c i t y - makes c a l c u l a t i o n easy. 7. S c r e e n a b i l i t y - l i n e s up w i t h o b j e c t i v e s c r e e n i n g standards. A word of c a u t i o n should be i n t e r j e c t e d here. C a p i t a l investment i s a c l e a r - c u t yes or no p r o p o s i t i o n on which management can and w i l l be judged. However, there i s a tendency to r e -15 J o e l Dean, " P r o f i t a b i l i t y I n d i c e s f o r C a p i t a l Investment", C o n t r o l l e r , February, 1958, p. 126. - 32 -g a r d s e e m i n g l y m e a n i n g f u l a r i t h m e t i c c a l c u l a -t i o n s a s t h e s o l e c r i t e r i o n to be u s e d i n a r r i v i n g a t a d e c i s i o n . These f o r m u l a e must be c o n s i d e r e d s u s p e c t i f management i s n o t b a l a n c i n g the c a l c u l a t i o n s w i t h l i b e r a l measures o f j u d g m e n t . Not a l l f a c t o r s a r e m e a s u r a b l e and t h e r e i s no s u b s t i t u t e f o r good j u d g m e n t . Two m a j o r a r e a s f o r c a p i t a l commit -ments a re r e p l a c e m e n t and e x p a n s i o n . U n d e r the c a t e g o r y o f r e p l a c e m e n t m i g h t be c o n s i d e r e d t h r e e s u b - d i v i s i o n s : the r e p l a c e m e n t o f o l d , w o r n o u t a s s e t s ; the r e p l a c e m e n t of o l d but sound a s s e t s w i t h newer ones w h i c h w i l l p r o d u c e more e f f i c i e n t -l y and w i t h s a v i n g s i n c o s t ; and the r e p l a c e m e n t o f e x i s t i n g a s s e t s w i t h new ones f o r the p u r p o s e of i m p r o v i n g p r o d u c t o r s e r v i c e . I n the f i r s t i n s t a n c e t h e r e p r e s u m a b l y i s no a l t e r n a t i v e f o r the e x p e n d i t u r e u n l e s s the o p e r a t i o n i s t o be d i s c o n t i n u e d . T h i s i n v o l v e s some judgment and v e r y l i k e l y l i t t l e i n the way of f o r m a l a s s e s s -ment o f r e t u r n on i n v e s t m e n t . I n the b r o a d sense o f c o u r s e , i t must be d e t e r m i n e d w h e t h e r i t i s more - 33 -p r o f i t a b l e to stay i n the b u s i n e s s or i n v e s t these funds elsewhere. In t h i s broad sense an e v a l u a t i o n should be made. When c o n s i d e r i n g a new a s s e t f o r pur-poses of co s t savings and i n c r e a s e d e f f i c i e n c y when the e x i s t i n g a s s e t i s not worn out, a q u a n t i t a t i v e e v a l u a t i o n of p r o f i t a b i l i t y should be made as a major f a c t o r i n a r r i v i n g at the d e c i s i o n . In the t h i r d category, where the d e s i r e to improve product o r s e r v i c e i s the prime con-s i d e r a t i o n , the d e c i s i o n w i l l have to be based p r i m a r i l y on judgment. A q u a n t i t a t i v e e v a l u a t i o n can only be u s e f u l i n t h i s i n s t a n c e to i n d i c a t e the extent to which the new o p e r a t i o n w i l l be as p r o f i t a b l e as the former one. When c o n s i d e r i n g the category of expan-s i o n , judgment a g a i n must weigh h e a v i l y i n the f i n a l d e c i s i o n . A new item may not be p r o f i t a b l e i n i t s e l f when measured by a formula, but may be necessary In the t o t a l o p e r a t i o n , or may c o n t r i b u t e to the p r o f i t a b i l i t y o f the t o t a l o p e r a t i o n . ©n the other hand, a very p r o f i t a b l e undertaking may - 34 -be inconsistent with the aims and objectives of the company. As a r e s u l t , i t may be seen that i n matters of expansion many factors be-sides the arithmetic calculations must be taken into consideration and the decision contains a substantial element of judgment. Reliance on a formula alone can be very misleading. Therefore, although the requirements of a good yardstick previously enumerated are very useful, i t w i l l not be possible to f i n d any yardstick which w i l l meet a l l requirements to the f u l l e s t extent that may be desirable. The yardstick selected must meet as many of the requirements as possible. In thi s way a more informed and precise evaluation i s made possible. CHAPTER 71 POSTPONABILITY AND PAYBACK AS MEASUREMENT CRITERIA The degree of n e c e s s i t y of the pro-posed p r o j e c t i s one measure of an investment p r o p o s a l . By t h i s i s meant, the extent to which a p r o j e c t cannot be postponed to l a t e r y e a r s . T h i s y a r d s t i c k i s a u s e f u l d e v i c e i n c a p i t a l budgeting. Some investments must be made j u s t to remain i n business, or to s a t i s f y government r e g u l a t o r y bodies. I f such i s the case, c l e a r l y the investment must be made r e g a r d l e s s of the economies of the p r o p o s a l . N e v e r t h e l e s s c a u t i o n must be used i n a p p l y i n g t h i s c r i t e r i o n . There i s a s e r i o u s d e f e c t to t h i s meas-urement - i t f a i l s to apply any q u a n t i t a t i v e meas ure of p r o d u c t i v i t y . By p r o d u c t i v i t y i s meant the e f f e c t on e a r n i n g s . Suppose, f o r example, the machine shop of a manufacturing company were destroyed by f i r e . I t would appear that r e p l a c e -ment of t h i s a s s e t would not be postponable. The - 36 -need i s of the highest p r i o r i t y . Yet i t might be found i f a p r o f i t a b i l i t y y a r d s t i c k were ap-p l i e d , that o v e r - a l l p r o f i t s might be enhanced i f t h i s work were subcontracted. C l e a r l y cau-t i o n i s i n order before accepting p r o j e c t s too b l i n d l y on a n e c e s s i t y b a s i s . The c h i e f weaknesses of p o s t p o n a b i l i t y as a c r i t e r i o n are: a) that i t does not consider a l t e r n a t i v e s b) i t does not measure earning power c) i t does not provide a b a s i s f o r rank-i n g proposals i n any order of p r i o r i t y . Payback i s the term a p p l i e d to the y a r d s t i c k that i s unquestionably the most widely used c r i t e r i o n f o r measuring investment proposals. Paybaek means the number of years r e q u i r e d f o r the earnings of a p r o j e c t to pay back the o r i g i n a l o u t l a y . I t i s probable that the very extensive use of t h i s measure i s a r e s u l t of a great deal of short term debt f i n a n c i n g . Under short term f i n a n c i n g c o n d i t i o n s , i t i s almost e s s e n t i a l that the earnings from a p r o j e c t be s u f f i c i e n t to pay back the funds borrowed to finance i t , unless - 37 -refinancing i s planned. This approach has become almost a by-word i n c a p i t a l expenditure proposals. Paybaok, l i k e postponability, i s also a useful tool i n c a p i t a l budgeting decisions. It i s superior to postponability i n that i t does consider earnings of a project. Its primary use should be as a coarse screen to select high pro-f i t projects for further consideration and to reject quickly those projects that show so l i t t l e promise as to merit no further consideration. It can also be used i n appraising projects with a high degree of r i s k and where the p o s s i b i l i t y of c a p i t a l d eterioration or wastage i s high. Since paybaek weighs early year earnings heavily and distance earnings not at a l l , i t contains a b u i l t i n hedge against technological obsolescence, and the p o s s i b i l i t y of a short economic l i f e . Payback does have some very serious l i m i t a t i o n s as a yardstick for investment decisions. It i s a cash concept and as a r e s u l t i t f a i l s to measure or r e f l e c t a l l the dimensions of p r o f i t -a b i l i t y which are relevant. F i r s t l y , payback tends to overemphasize the importance of liquidity as a goal. No firm can ignore liq u i d i t y but long term profits need not necessarily be subordinated to i t . Secondly, payback ignores probable economic l i f e . It gives no consideration to. earnings of a project after the original outlay has been repaid. At the end of the payback period the project has s t i l l pro-duced no net earnings. It is the earnings from this point on that really determine the benefit &t the project. Payback is neither sensitive enough nor sufficiently inclusive to be employed as the sole criterion for capital budgeting decisions. CHAPTER 711 THE RETURN ON INVESTMENT CONCEPT The phrase " r e t u r n on investment" i s used t o i n c l u d e a wide v a r i e t y of b a s i c a l l y s i m i l a r approaches to the problem of measurement but which d i f f e r c o n s i d e r a b l y i n c e r t a i n r e s p e c t s . B a s i c a l l y the concept i s t h a t of p r o f i t a b i l i t y , that i s , a d d i t i o n a l r e t u r n as a r e s u l t of add-i t i o n a l investment. The methods used i n a r e t u r n on i n -vestment concept e i t h e r determins what the r a t e of r e t u r n f o r an i n d i v i d u a l p r o j e c t would be, or a l t e r n a t i v e l y , e s t a b l i s h a minimum standard to ensure t h a t a s a t i s f a c t o r y r e t u r n i s earned on a l l p r o j e c t s . A v a r i e t y of d i f f e r e n t names are used such as, I n t e r e s t Rate of Return, the I n v e s t o r s Method, the Discounted Gash Flow, the P r o f i t a b i l i t y Index, C a p i t a l i z e d Cost, Present Worth Method, and Annual C o s t s . The g e n e r a l term " d i s c o u n t methods" may be a p p l i e d to them a l l f o r purposes of g e n e r a l c o n s i d e r a t i o n . - 40 -B a s i c a l l y the study of t h i s concept i s a study of why people borrow and lend money. Those who have accumulated savings which they cannot or do not wish to use at the present time are the p o t e n t i a l lenders. The p o t e n t i a l borrow-ers are those who could make p r o f i t a b l e use of funds which they have not got at t h e i r d i s p o s a l . The compensation paid by borrower to lender f o r use of the lender's money i s c a l l e d " i n t e r e s t " , and i s the foundation of the r a t e of r e t u r n con-cept of measurement. When a p p r a i s i n g a c a p i t a l expenditure proposal, f u t u r e b e n e f i t s from i t are assessed, according to a discount method i n terms of the cash generated by the p r o j e c t each year. There-f o r e , one can see that the r a t e of r e t u r n concept f o r a c a p i t a l expenditure i s fundamentally the same as the y i e l d on an investment concept. There are two b a s i c approaches. The f i r s t i s to discount a l l f u t u r e cash r e c e i p t s to t h e i r present value at the r a t e of r e t u r n ( i n t e r -e st) which would make the sum of t h e i r present values equal to the c a p i t a l expenditure. The seoond - 41 -approach i s to d i s c o u n t the f u t u r e cash r e c e i p t s back at a minimum acceptable r a t e of r e t u r n . I f the sum of t h e i r present v a l u e s exeeeds the c a p i t a l expenditure the r a t e of r e t u r n i s a c c e p t a b l e . T h e r e f o r e , we can e s t a b l i s h a g e n e r a l d e f i n i t i o n : The r a t e of r e t u r n (under d i s c o u n t methods) i s e q u i v a l e n t to the maximum r a t e of i n t e r e s t a t which money c o u l d be borrowed to f i n a n c e a p r o j e c t , and p a i d back as i t becomes a v a i l a b l e through e a r n i n g s , so t h a t the debt i s l i q u i d a t e d by the end of the economic l i f e o f the p r o j e c t . A l t e r n a t i v e l y i t i s the maximum r a t e o f i n t e r e s t which, when used to d i s c o u n t a l l f u t u r e cash r e c e i p t s , would make t h e i r present worth equal to the c a p i t a l expenditure which generated them.16 A sound method of determining r a t e of r e t u r n on c a p i t a l investment should take i n t o c o n s i d e r a t i o n the f o l l o w i n g : 1. c o s t of a p r o j e c t , e a r n i n g s from i t , and the l e n g t h of i t s u s e f u l l i f e £. r e c o g n i z e that a sum of money r e c e i v e d at some f u t u r e date i s worth l e s s than 16 C G . Edge, The A p p r a i s a l of C a p i t a l Expen- d i t u r e , p. TTT - 42 -that same sum today 3. be able to translate a future sum into i t s equivalent today. The discount methods that meet these tests provide a sound objective method of evalua-tion for the financial factors pertinent to an investment decision. As mentioned previously other factors w i l l often play a large part in the f i n a l decision. The return on investment method should not be used alone, but should be one seg-ment of the whole set of factors contributing to making a sound decision. Another consideration that must be emphasized is that the cost of a project, the earnings from i t , and the length of i t s useful l i f e are often very inaccurate or uncertain est-imates at the time the proposal i s being consider-ed. As a result, even though a very precise method of evaluation may be applied, the resultant quant-itative answer may be significantly inaccurate. This, i t w i l l be seen, may be a major shortcoming of the return on investment criterion of measure-ment. CHAPTER V I I I THE PRACTICAL APPLICATION OP DISCOUNT METHODS The p r i n c i p l e s l i n k i n g present c a p i t a l e xpenditures to f u t u r e economic b e n e f i t s have been d i s c u s s e d . The purpose of t h i s s e c t i o n i s to i l -l u s t r a t e some p r a c t i c a l a p p l i c a t i o n s of these p r i n -c i p l e s . As mentioned p r e v i o u s l y there are s e v e r a l v a r i a n t s of the d i s c o u n t approach, a l l of them us-i n g compound i n t e r e s t formulae. A l l of these methods, however, y i e l d v i r t u a l l y e q u i v a l e n t r e -s u l t s . Some of the methods use continuous i n t e r e s t t a b l e s , o t h e r s assume i n t e r e s t i s c a l c u l a t e d a t the end of each year; some assume c o s t s and income are i n c u r r e d a t the beginning, d u r i n g , or at the end of a y e a r . Some methods, when u s i n g minimum r a t e s of r e t u r n , convert c a p i t a l c o s t s to equiv-a l e n t annual c o s t s , others convert annual c o s t s to c a p i t a l c o s t s . The v a r i o u s formulae a l s o tend to become more complex as more f a c t o r s are i n -corporated i n them. - 44 -As p r e v i o u s l y d e f i n e d , there are two b a s i c approaches to t h i s problem. The f i r s t i s the use of a minimum r a t e of r e t u r n to ensure that the proposed investment y i e l d s a r a t e of r e t u r n above the minimum. The examples which f o l l o w w i l l i l l u s t r a t e t h i s approach by the "annual c o s t " method. The a l t e r n a t i v e approach i s to c a l c u l a t e the r a t e of r e t u r n of a p r o p o s a l which can then be compared to an accepted minimum r a t e of r e t u r n . Examples 14-17 which f o l l o w i l l u s t r a t e t h i s method. The annual c o s t method i s w e l l s u i t e d f o r e v a l u a t i o n of those p r o j e c t s such as cost r e d u c t i o n , replacement, and a l t e r n a t i v e s i n equip-ment. The r a t e of r e t u r n method i s b e t t e r s u i t e d to p r o j e c t s such as expansion p r o j e c t s , where r i s k i s a l a r g e r f a c t o r . The r a t e of r e t u r n f o r these p r o j e c t s can be compared to a minimum r a t e of r e -t u r n , and the s a f e t y margin between the two more c l e a r l y seen. The e v a l u a t i o n of the adequacy of the s a f e t y margin, i t must be noted, r e q u i r e s judgment, and the mere e x i s t e n c e of a margin of s a f e t y i s i n s u f f i c i e n t evidence on which to base - 45 -a d e c i s i o n . A r e l a t i v e l y simple approach i s used 1 7 i n a l l the examples which f o l l o w , x i n order to i l l u s t r a t e the techniques i n v o l v e d . The assump-t i o n s used are as f o l l o w s : 1. Minimum r a t e of r e t u r n w i l l be assumed at 17%. A t a b l e f o r use w i t h t h i s percentage i s g i v e n . (This minimum r a t e of 17^ > has no p a r t i c u l a r s i g n i f i c a n c e other than the f a o t that i t i s arb-i t r a r i l y assumed to be the min-? imum accept a b l e r a t e of r e t u r n f o r the p r o p o s a l s i n v o l v e d i n the examples.) 2. Costs and income i n c u r r e d dur-i n g a year w i l l be assumed to occur at the end of the y e a r . Normally t h i s does not produce any s i g n i f i c a n t i n a c c u r a c y . 3. C a p i t a l expenditures are assumed to occur a t the beginning of the year. 4. A l l c a l c u l a t i o n s are on a " b e f o r e -tax" b a s i s . Appendix B i l l u s t r a t e s the a p p l i c a t i o n of these formulae w i t h examples on an " a f t e r - t a x " b a s i s . 5. Formulae: P = present worth of a f u t u r e sum of money S = f u t u r e value of a sum of money 17 C G . Edge, The A p p r a i s a l of C a p i t a l Expen- d i t u r e , pp. 27-47. - 46 -a) c) R = annual cost at the end of each year i = r a t e of i n t e r e s t or r a t e of r e t u r n on investment n - number of years Present Worth F a c t o r : P. S " (TT (This formula i s used to f i n d the present worth of a s i n g l e sum of money.) b) S i n k i n g Fund Factor: R - S (1+ i J A - 1 (This formula i s used w i t h salvage values to convert them to equivalent annual costs.) C a p i t a l Recovery Factor: R = P l ( l t l ) a (1+ i ) h - 1 (This formula i s used to convert a c a p i t a l expenditure today to the equivalent s e r i e s of equal annual cos t s based on the economic l i f e of the asset.) - 47 -INTEREST TABLE.FOE 17$ RATE OF RETURN PRESENT WORTH FACTORS (F) (1 + i ) n SINKING FUND FACTORS f»ef> ( U i ) n - 1 CAPITAL RECOVERY FACTORS ( F c r ) i ( l + i ) n (1+ l ) n _ ; n i-Years 1 0.8547 1.0000 1.1700 2 0.7305 0.4608 0.6308 3 0.6244 0.2826 0.4526 4 0.5337 0.1945 0.3646 5 0.4561 0.1426 0.3126 6 0.3898 0.1086 0.2786 7 0.3332 0.0849 0.2549 8 0.2848 0.0677 0.2377 9 0.2434 0.0547 0.2247 10 0.2080 0.0447 0.2146 11 0.1778 0.0368 0.2068 12 0.1520 0.0305 0.2005 13 0.1299 0.0254 0.1954 14 0.1110 0.0212 0.1912 15 0.0949 0.0178 0.1878 16 0.0811 0.0150 0.1850 17 0.0693 0.0127 0.1827 18 0.0592 0.0107 0.1807 19 0.0506 0.0091 0.1791 20 0.0433 0.0077 0.1777 21 0.0370 0.0065 0.1765 22 0.0316 0.0056 0.1755 23 0.0270 0.0047 0.1747 24 0.0231 0.0040 0.1740 25 0.0197 0.0034 0.1734 26 0.0169 0.0029 0.1729 27 0.0144 0.0025 0.1725 28 0.0123 0.0021 0.1721 29 0.0105 0.0018 0.1718 30 0.0090 0.0015 0.1715 48 -F - Used to c a l c u l a t e present value of s i n g l e payments "n" years from p r e s e n t . F s f - Used to c a l c u l a t e s e r i e s of "n" annual payments which w i l l accumulate.a g i v e n sum at the end of "n" ye a r s ( S i n k i n g Fund F a o t o r s o f t e n used to convert s a l -vage v a l u e s i n t o e q u i v a l e n t annual pay-ments). F o r - Used to c a l c u l a t e s e r i e s of "n" annual payments which w i l l be y i e l d e d by a give n sum i n v e s t e d now ( c a p i t a l recovery f a c t o r s o f t e n used to convert c a p i t a l cost i n t o e q u i v a l e n t annual c o s t s ) . ANNUAL COST METHOD - CHOICE OF ALTERNATIVE EQUIPMENT; Example 1 Comparison of two a l t e r n a t i v e s w i t h d i f f e r e n t investments and u s e f u l economic l i v e s . Operating c o s t s assumed to be the same i n each case. Problem A s t e e l storage tank c o s t i n g $10,000 l a s t s 5 y e a r s . A s t a i n l e s s s t e e l one, o o s t i n g $25,000, l a s t s 20 y e a r s . Which i s p r e f e r a b l e ? P r i n c i p l e Use the c a p i t a l r e c o v e r y f a c t o r to con-v e r t e a p i t a l c o s t s i n t o annual c o s t s . I t i s assumed that the s t e e l tank can be r e p l a c e d every f i v e y e a r s f o r $10,000. S o l u t i o n Annual cost of S t e e l Tank - 10,000x 0.3126= $3,126 Annual c o s t of S t a i n l e s s S t e e l Tank = 25,000x 0.1777= $4,444 Since the s t e e l tank y i e l d s lower annual c o s t s , choose the s t e e l tank. - 49 -Example 2 Problem P r i n c i p l e S o l u t i o n Example 3 Problem Comparison of two a l t e r n a t i v e s w i t h d i f f e r e n t investments and l i v e s , and a l s o d i f f e r e n t maintenance c o s t s . A s t e e l tank c o s t s $10,000, l a s t s 5 y e a r s , maintenance c o s t s are $1,600 a y e a r . S t a i n l e s s s t e e l tank c o s t s $£5,000, l a s t s 20 y e a r s , maintenance c o s t s are #100 a year, Convert the c a p i t a l c o s t s to annual c o s t s . Add them to the annual operat-in g c o s t s and f i n d the p r o p o s a l which has the lowest t o t a l c o s t . S t e e l Tank — Annual Cost 10,000X 0.3126= $3,126 Maintenance Costs 1,600 T o t a l Annual Cost $4,726 S t a i n l e s s S t e e l Tank Annual Cost 25,000X0.1777= $4,444 Maintenance Costs , 100 T o t a l Annual Cost $4,544 Therefore, choose the S t a i n l e s s S t e e l Tank. Comparison of a l t e r n a t i v e s w i t h d i f -f e r e n t investments and l i v e s , operat-i n g c o s t s and salvage v a l u e s . Estimated salvage value of s t e e l tank a f t e r 5 years i s $1,000 and s t a i n l e s s s t e e l tank, a f t e r 20 y e a r s , i s $2,000. C a p i t a l Cost L i f e - y e a r s Maintenance c o s t s S t e e l Tank $10,000 5 S.S. Tank $25,000 20 per y e a r Salvage value 1,600 1,000 100 2,000 - 50 -P r i n c i p l e Convert the salvage v a l u e s , using s i n k i n g fund f a c t o r s , to the equiv-a l e n t annual amount. I t would, i n f a c t , be a negative cost and deduct-ed from the other c o s t s . S o l u t i o n S t e e l Capital-Annual Cost $3,126 Maintenance 1,600 Salvage Yalue: 1,000*0.1426 (143) 2,000 * 0.0077 . T o t a l Annual Cost $4,583 S t a i n l e s s $4,444 100 (15) |4,529 Therefore, choose the S t a i n l e s s S t e e l Tank. Example 4 Sometimes i t i s d e s i r a b l e to estimate the e f f e c t of higher maintenance costs on the length of l i f e of an asset. Problem A s t e e l tank cos t s $10,000 and l a s t s 5 years. I s i t worthwhile to extend i t s l i f e by 3 years by p a i n t i n g i t annually at a cost of $300? P r i n c i p l e Use the c a p i t a l recovery f a c t o r to f i n d which a l t e r n a t i v e has the lowest annual cost. S o l u t i o n S t e e l tank l a s t i n g f i v e years Annual cost of c a p i t a l 10,000 x 0.3126= |3JL26 S t e e l tank l a s t i n g eight years Annual cost of c a p i t a l 10,000* 0.2377 = $2,377 Maintenance costs per year 300 Tota l Annual Cost $2,677 Therefore p a i n t tank and replace every eig h t years. - 51 -Example 5 A l s o , one can determine how much more c a p i t a l one c o u l d spend to get a d e s i r e d e f f e c t . Problem I f a s t e e l tank l a s t s 5 y e a r s and c o s t s $10,000, how muoh could one spend f o r a tank l a s t i n g 20 y e a r s ? P r i n c i p l e F i n d the annual c o s t f o r the f i v e year tank and then f i n d the e q u i v a l e n t cap-i t a l f o r a 20 year l i f e . S o l u t i o n Annual c o s t of 5 year tank lO.OOOx 0.3126 = $3,126 C a p i t a l Recovery F a c t o r - 20 years 0.1777 Therefore c a p i t a l c ost i f l i f e 20 y e a r s 3,126 , $17,591 Therefore a 20 year tank should not cost more than $17,591 to be b e t t e r than a $10,000 tank l a s t i n g f i v e y e a r s . Example 6 Sometimes there are p e r i o d i c c o s t s such as an overhaul of a t r a c t o r every three y e a r s . Problem What i s the average annual cost of a t r a c t o r c o s t i n g $30,000 w i t h a 9 year l i f e and salvage value of |2,000. A l s o , an over h a u l c o s t i n g $3,000 i s needed every three y e a r s . No overhaul i s assumed a t the end of the n i n t h y e a r . P r i n c i p l e I f the overhauls occur at the end of every three y e a r s , the s i n k i n g fund formula would be used to convert them i n t o the e q u i v a l e n t annual c o s t s . However, an &d-justment may be needed to t h i s r e s u l t . T h i s i s because i t would be unusual f o r an overhaul to take p l a c e j u s t p r i o r to the v e h i c l e being s o l d . T h e r e f o r e , i n t h i s example, the cost of the overhaul at the end of the n i n t h year and which would not - 52 -take p l a c e , would be converted to the e q u i v a l e n t annual c o s t and ap-p l i e d as a c r e d i t to reduce the overh a u l cost per ye a r . I f the overhauls occur a t the beginning of every three y e a r s , the c a p i t a l r e c o v e r y f a c t o r would be used. S o l u t i o n Annual c o s t of c a p i t a l 30,000* 0.2247= #6,741 Annual c o s t of salvage value 2,000x 0.0547 = (109) Annual cost of overhaul every 'three y e a r s 3,000 x 0.2826 - 848 Adjustment i f l a s t o verhaul does not take p l a c e 3,000^0.0547= (164) T o t a l Annual Cost $7.316 Example 7 Often c o s t s w i l l not be the same each year as maintenance c o s t s i n c r e a s e each year. A l s o , overhaul may occur at d i f f e r e n t i n t e r v a l s and d i f f e r e n t amounts. Problem What i s the annual c o s t of a truck w i t h a c a p i t a l c ost of $20,000 l a s t i n g f o r 5 y e a r s , with a salvage value of $2,000? Maintenance c o s t s are $300 f o r the f i r s t year, i n c r e a s i n g by $100 a year t h e r e a f t e r . A l s o an over h a u l o f $2,000 i s needed i n the t h i r d y e a r . P r i n c i p l e Where c o s t s vary each year, they are converted back to t h e i r present worth using the present worth formula. The present worths are then t o t a l l e d and converted back to a l e v e l 'annual' c o s t . - 53 -S o l u t i o n Present Wth. C a p i t a l Cost 20,000 * 1.0 #20,000 Maintenance Costs: 1st y e a r 300x 0.8547 256 2nd y e a r 400 x 0.7305 292 3rd y e a r 500 x 0.6244 312 4th y e a r 600 x 0.5337 320 5th y e a r 700 x 0.4561 319 Overhaul 3rd yea r 2,000 x 0.6244 1,249 Salvage value at 5th year 2,000 x 0.4561 (912) 121,836 Th e r e f o r e , a present worth of #21,836 i s e q u i v a l e n t to an annual cost f o r 5 years of 21,836x 0.3126 = | 6,826 COST REDUCTION: Cost r e d u c t i o n p r o j e c t s can e i t h e r be evaluated by the annual cost method or by c a l -c u l a t i n g the r e t u r n on investment. The f o l l o w i n g examples use the annual cost method and compare the annual cost of the c a p i t a l investment with cost s a v i n g . I f the c o s t saving i s g r e a t e r , the p r o j e c t i s d e s i r a b l e . Example 8 Cost savings are the same each y e a r . Problem A new packing machine c o s t s $10,000, i s estimated to l a s t 5 years w i t h no salvage value and r e s u l t s i n cost savings of $3,000. Is the p r o j e c t worthwhile? S o l u t i o n Annual cost of machine: 10,000* 0.3126 ($3,126) 3,000_ Added earnings ($ 126) Th e r e f o r e , cost savings are inadequate to j u s t i f y the machine. - 54 -Example 9 Estimate of oost savings needed to j u s t i f y new equipment. Problem A b a l e - t y i n g machine c o s t s $80,000, i s estimated to l a s t 8 y e a r s and the salvage value i s $2,000. What minimum cost savings are needed to j u s t i f y i t s purchase ? S o l u t i o n Annual c o s t of machine: 20,000 * 0.2377 = $4,754 Annual oost of salv a g e : 2,000 * 0.0677= (135) Minimum Cost Savings Needed=14,619 REPLACEMENT: Replacement of equipment i s o f t e n a reason f o r new c a p i t a l e x p e nditure. The qu e s t i o n s are g e n e r a l l y i n two p a r t s - "Why r e p l a c e now" and "Why r e p l a c e w i t h t h i s p a r t i c u l a r type of equip-ment?" I t i s assumed t h a t the q u e s t i o n of "Why r e p l a c e at a l l ? " has been answered i n the a f f i r m -a t i v e . T h e r e f o r e , there are three estimates r e -q u i r e d : ( i ) the oost of c o n t i n u i n g w i t h the e x i s t i n g equipment f o r one more y e a r . ( i i ) the average annual cost of new equipment of the same type. T h i s should be based on the i d e a l economic l i f e , s i n c e t h i s w i l l y i e l d the lowest annual c o s t f o r t h i s equipment. ( i i i ) the average annual cost of other new equipment which could do the same job, p o s s i b l y a t lower cost than the type a l r e a d y i n use. The lowest annual c o s t of these a l t e r -n a t i v e s would be p r e f e r r e d . "Annual Cost" methods - 55 -are i d e a l l y s u i t e d f o r these replacement problems. Examples w i l l be g i v e n of each phase of the comparison. Replacement problems e s s e n t i a l l y revolve around the timing of replacement of e x i s t i n g equip-ment, since a l l equipment wears out or becomes ob-s o l e t e . A l s o , they have a cost r e d u c t i o n aspect, since replacement by d i f f e r e n t equipment r a t h e r than . the same type i s e s s e n t i a l l y a cost r e d u c t i o n p r o j e c t . Example 10 To determine the cost of c o n t i n u i n g w i t h e x i s t i n g equipment. Problem The present salvage value of a t r a c t o r i s #10,000. In one year's time i t s salvage value w i l l have d e c l i n e d to $7,5000. Maintenance and r e p a i r c o s t s f o r the year are estimated at $16,000. P r i n c i p l e The cost of continuing w i t h the e x i s t r ing equipment f o r one more year c o n s i s t s of: f i ) o p e r a t i n g c o s t s f o r the year, ( i i ) d e c l i n e i n salvage value - s i n c e t h i s means l o s s of cash by not s e l l i n g immediately. ( i i i ) the minimum r e t u r n on investment on the salvage value at the be-g i n n i n g of the year. This i s because, i f the t r a c t o r were s o l d immediately, the oash recovered from the sale could earn at l e a s t the minimum r a t e of r e t u r n , i f used elsewhere i n the company. S o l u t i o n Maintenance and r e p a i r costs = $16,000 Decline i n salvage value: 10,000 - 7,500 = £,500 Return on salvage value at beginning of year: 17% of $10,000 = 1,700 T o t a l cost f o r one more year f20,200 - 56 -Example 11 O c c a s i o n a l l y , where a major overhaul takes place i n the year and t h i s i s not f u l l y r e f l e c t e d i n salvage v a l u e s , the annual cost of co n t i n u i n g w i t h e x i s t i n g equipment i s lower, i f more than one year i s concerned. Problem Salvage Maintenance and Value Overhaul Now #10,000 1st year 7,500 #16,000 End year 6,000 9,000 3rd year 2,000 12,000 I s the annual cost of t h i s e x i s t i n g equipment lowest f o r one more year, or should the equipment b6 kept longer? S o l u t i o n I f kept one year: Maintenance Cost =#16,000 C a p i t a l Cost f o r 1 year 10,000x 1.17= 11,700 Salvage Value 7,500 x 1.0 = (7,500) Annual Cost f o r 1 year f20,200 I f kept two years: Present Worth Maintenance: 1st year 16,000x 0.8547 =#13,675 2nd year 9,000x 0.7305 = 6,575 Salvage Value: Now 10,000 x 1.0 = 10,000 i n 2 years 6,000 * 0.7305 = (4,383) Present Worth T o t a l f25.86.7 Annual Cost f o r 2 years: 25,867 x 0.6308 = #16,317 I f kept three years: Present Worth Maintenance: 1st year 16,OOOx 0.8547= #13,675 2nd year 9,000* 0.7305 = 6,575 3rd year 12,000* 0.6244 - 7,493 - 57 -Salvage V a l u e : Now 10,000X1.0 =10,000 i n 3 years £,000 x 0.6244 = (1,249) T o t a l Present Worth $36.494 Annual Cost f o r 3 y e a r s 36,494X 0.4526 = #16,517 The r e f o r e , the annual c o s t of keeping e x i s t i n g equipment f o r two more years should be used i n comparing w i t h the annual cost of new equipment. Example 12 To f i n d the economic l i f e of new equip-ment. Problem A t r a c t o r c o s t i n g $30,000 i s estimated to have the f o l l o w i n g o p e r a t i n g and maintenance c o s t s : Operating and Salvage Year Maintenance Costs V a l u e s 1 $10,400 $20,000 2 11,300 15,000 3 12,220 11,000 4 13,160 8,000 5 14,120 6,000 6 15,100 4,000 7 16,100 3,000 8 17,100 2,000 9 18,600 — 10 20,600 -P r i n c i p l e Determine the average annual cost i f kept f o r one year, two y e a r s , three y e a r s , e t c . , as f o l l o w s : ( i ) convert the c a p i t a l cost i n t o the annual eost acoording to the number of y e a r s f o r which the equipment i s kept. ( i i ) convert the salvage value i n t o a n e g a t i v e annual cost u s i n g the s i n k -i n g fund f a c t o r . - 58 -( i i i ) convert the operating and maintenance costs each year to t h e i r present worth. Add the present worths and reconvert to l e v e l annual c o s t s using the c a p i t a l recovery f a c t o r s . ( i v ) add the annual cost f o r the cap-i t a l oost, salvage v a l u e , and ope r a t i n g and maintenance costs and f i n d which year g i v e s the t o t a l lowest oost. S o l u t i o n This i s given i n the attached table and i n d i c a t e s the annual oost i s lowest at #19,910 f o r 8 years, page 59. COMMENTS: While not included i n the above examples, i n determining the i d e a l economic l i f e , c o n s i d e r a t i o n should be given to the u n r e l i a b i l i t y and p r o d u c t i v i t y of o l d equipment and a l s o obsolescence. For example, i f equipment i s l i a b l e to breakdown, equipment may have to be rented to do the work which the e x i s t i n g equipment should have perform-ed. I t may, t h e r e f o r e , be d e s i r a b l e to include these a d d i t i o n a l c o s t s of u n r e l i a b i l i t y i n the estimates of operating costs each year. Secondly, new and b e t t e r equipment i s con-t i n u a l l y being developed. This newer equipment would have lower annual costs and r e s u l t i n equipment now being i n s t a l l e d to be replaced sooner. I f t h i s equipment now being I n s t a l l e d i s replaced sooner, i t s annual costs w i l l be higher. Therefore i t may be d e s i r a b l e to base costs on a shorter l i f e than that i n d i c a t e d by the methods proposed i n Example 12. P r o b a b i l i t y f a c t o r s can a l s o be used to assess the impact of obsolescence. - 59 -DETERMINATION OF IDEAL ECONOMIC LIFE FOR A TRACTOR (Example 1£) Yr s . Inv't Trade-in-Value Operating Costs (1) (3) (5) (6) (7) A c t u a l I 0 30,000 1 £ 3 4 5 6 7 8 9 10 A c t u a l 1 A c t u a l 1 P.-Wth. $ Cu. P. I £0,000 10,400 8,890 8,890 15,000 11,300 8,250 17,140 11,000 12,220 7,730 24,770 8,000 13,160 7,020 31,790 6,000 14,120 6,440 38,230 4,000 15,100 5,890 44,120 3,000 16,100 5,360 49,480 2,000 17,100 4,870 54,350 - 18,600 4,530 58,880 - 20,600 4,280 63,160 Annual Annual Cost Cost (2) # 'I 1 0 1 35,100 (20,000) 2 18,920 ( 6,910) 3 13,580 ( 3,110) 4 10,940 ( 1,560) 5 9,380 ( 860) 6 8,360 ( 430) 7 7,650 ( . 250) 8 7,130 ( 140) 9 6,740 — 10 6,440 -Notes • Annual Cost (8) T o t a l Annual Cost (?) 10,400 10,810 11,210 11,590 11,950 12,290 12,610 12,920 13,230 13,550 25,500 22,820 21,680 20,970 20,470 20,££0 20,010 19,910 19,970 19,990 (a) Column (9) Column (2) Column (4) Column (8) (b) Column (5) i n c l u d e s o p e r a t i n g , maintenance and i n -surance c o s t s , but no d e p r e c i a t i o n o r o p e r a t i n g labour, .(c) Columns (2) and (8) - C a l c u l a t e d u s i n g F c r F a c t o r s . (d) Column (4) - C a l c u l a t e d u s i n g F s f F a c t o r s . (e) Column (6) - C a l c u l a t e d u s i n g F F a c t o r s . ( f ) * I d e a l economic l e n g t h of l i f e - 8 y e a r s . - 60 -Example 13 To determine whether equipment should he r e p l a c e d . Problem Estimated annual cost of c o n t i n u i n g w i t h e x i s t i n g equipment f o r one more year (Example 10). $20,200 Estimated annual cost of c o n t i n u i n g w i t h e x i s t i n g equipment f o r two more years (Example 11). $16,317 Estimated annual cost of new equipment of the same type (Example 12).$19,910 Estimated annual cost of new equip-ment of a d i f f e r e n t type ( d e t a i l s not g i v e n , but would be the same type of estimate as i n Example 12). #16,000 S o l u t i o n Since new equipment of a d i f f e r e n t type y i e l d s the lowest annual cost based on the methods des c r i b e d , i t should be used to replace e x i s t i n g equipment. - 61 -RETURN ON INVESTMENT COST REDUCTION: Example 14 Cost r e d u c t i o n - based on the same d o l l a r s aving each y e a r . Problem A new machine c o s t i n g $100,000 w i t h a l i f e of 10 y e a r s and no salvage v a l u e , i s estimated to save labour c o s t s of $40,000 a year. Maintenance c o s t s on the new machine are estimated at $10,000 a year. P r i n c i p l e F i n d the r a t i o of the annual savings i n cash c o s t s to the c a p i t a l o o s t . Then f i n d the r a t e of i n t e r e s t a p p l i c a b l e t o t h i s r a t i o . D e p r e c i a t i o n i s ignored s i n c e i t i s a non-cash c o s t . S o l u t i o n Gross c o s t savings Increase i n c o s t s due to new machine Net cost saving (cash) C a p i t a l c o s t R a t i o of c o s t c a p i t a l cost s a v i n g to $40,000 10,000  30,000 100,000 0.3000 Prom i n s p e c t i o n of i n t e r e s t t a b l e s : C a p i t a l Recovery F a c t o r f o r 27% f o r 10 years 0.2972 C a p i t a l Recovery F a c t o r f o r 28% f o r 10 years 0.3059 By i n t e r p o l a t i o n , the r a t e of r e t u r n on investment: - 27 + (3000 - 2972^ " V 3 6 6 9 - 2972/ - 27-1. 28 = 27.3% - 62 -EXPANSION: Example 15 Expansion - based on l e v e l annual e a r n i n g s . Problem P r i n c i p l e S o l u t i o n Equipment f o r a new product i s estimated at $200,000 w i t h a 20 year l i f e and no salvage v a l u e . P r o f i t before d e p r e c i a ^ t i o n i s estimated a t $30,000. What i s the r e t u r n on investment? P r o f i t before d e p r e c i a t i o n i s e q u i v a l e n t to the 'Cash In-flow' per ye a r . F i n d the r a t i o of the cash i n - f l o w to the c a p i t a l cost and f i n d the r a t e of i n t e r e s t which g i v e s the same r a t i o f o r the c a p i t a l r e c o v e r y f a c t o r . Cash i n - f l o w per year C a p i t a l cost R a t i o of cash i n - f l o w to out-flow $ 30,000 200,000 0.15000 Prom i n s p e c t i o n of i n t e r e s t t a b l e s : 0.1424 0.1510 C a p i t a l Recovery F a c t o r f o r 13% f o r 20 y e a r s C a p i t a l Recovery F a c t o r f o r 14% f o r 20 years By i n t e r p o l a t i o n , the r a t e of r e t u r n on investment: 13.9% Example 16 Expansion - based on v a r y i n g l e v e l s of e a r n i n g s . Problem A c a p i t a l expenditure of $100,000 i s estimated to generate the f o l l o w i n g e a r n i n g s f o r f i v e y e a r s . P r o f i t Before D e p r e c i a t i o n Year 1 $ 5,000 Year 2 15,000 Year 3 30,000 Year 4 35,000 Year 5 40,000 What i s the r a t e of r e t u r n on investment? 63 -P r i n c i p l e Find the r a t e of i n t e r e s t which w i l l make the present worth of a l l f u t u r e cash i n - f l o w s equal to the c a p i t a l expenditure. Since the r a t e of i n t e r e s t i s found by t r i a l and e r r o r , i t i s a u s e f u l guide to average the cash i n - f l o w and f i n d the c a p i t a l recovery f a c t o r which equates i t to the c a p i t a l expend-i t u r e . For example, the average p r o f i t before taxes i s 125,000 or 0.2500 of the c a p i t a l expenditure, which g i v e s a s t a r t -ing point of 8$. S o l u t i o n I n t e r e s t Rate 8% I n t e r e s t Rate 6$ Cash Present Present Present Present Year Flow Worth F. Worth Worth F. Worth I'OOO $'000 #'000 0 (100) 1.0 (100.0) 1.0 (100.0) 1 5 . 0.9259 4.6. 0.9434 4.7-2 15 0.8573 12.9 0.8900 13.4 3 30 0.7938 23.8 0.8396 25.2 4 35 0.7350 25.7 0.7921 27.7 5 40 0.6806 27.2 0.7473 29.9 ( 5.8) 0.9 Therefore the r a t e of r e t u r n on i n v e s t -ment : ' • a 6 + L 6 ° ' 9 A n) * 2 V5.8 + 0.9/ = 6.3% Example 17 Expansion - based on v a r y i n g l e v e l s of earnings. Problem A new machine c o s t i n g $200,000 i s ex-pected to l a s t 8 years and have a salvage value of $30,000. A d d i t i o n a l working c a p i t a l of $60,000 would a l s o be needed. Earnings expected to r e s u l t are as f o l l o w s : P r o f i t Before D e p r e c i a t i o n Year :. $'000 Year 1 .70 Year 2 65 Year 3 60 - 64 -Year 4 40 Year 5 50 Year 6 30 Year 7 30 Year 8 £0 P r i n c i p l e Same as i n Example-16. Treat the working c a p i t a l as a cash out-flow at the beginning and as i n - f l o w at the end of the l i f e of the equipment. S i m i l a r l y , salvage v a l u e would be an i n - f l o w at the end of the l i f e of the equipment. S o l u t i o n I n t e r e s t Rate 15% I n t e r e s t Rate 14% Cash Present Present Present Present Year Plow Worth P. Worth Worth P. Worth |» 000 $'000 $'000 0 (£60) 1.0 (£60.0) 1.0 (£60.0) 1 70- 0.8696 60.9. 0.877E 61.4 E 65 0.7561 49.1 0.7695 50.0 3 60 0.6575 39.5 0.6750 40.5 4 40 0.5718 ££.9 0.59E1 23.7 5 50 0.497E £4.9 0.5194 26.0 6 30 0.4323 13.0 0.4556 13.7 7 30 0.3759 11.3 0.3996 12.0 8 110* 0.3S69 36.0 0.3506 38.6 ( £.4) o.9 T h e r e f o r e , the r a t e of r e t u r n on invest' ment: --14.7% * ( P r o f i t #£0,000 Recovery of Working C a p i t a l $60,000 Salvage Value #30,000) CHAPTER IX A SURVEY OP PRACTICE In order to examine c r i t i c a l l y the concept of c a p i t a l budgeting that has been out-l i n e d here, a study of s e v e r a l companies and i n d u s t r i e s was undertaken. In t h i s survey the answers to the f o l l o w i n g questions were sought: 1. Are these p r i n c i p l e s being a p p l i e d ? £. I f they are, what i s t h e i r value to management? 3. I f t h i s technique i s not being used, what, i f anything, was being used instead? 4, Can the procedures o u t l i n e d here be broadly a p p l i e d to d e c i s i o n s of t h i s nature and are the c r i t e r i a proposed of p r a c t i c a l value to the a d m i n i s t r a t o r ? I t i s i n t e r e s t i n g to note that even i n such a f i e l d as municipal a d m i n i s t r a t i o n , a t t e n t i o n - 66 -i s being g i v e n to c a p i t a l budgeting. F i n a n r o i a l Post r e p o r t e d i n i t s i s s u e of November 21, 1959, that the C i t y of Hamilton, O n t a r i o , has adopted a p o l i c y of c a p i t a l budgeting. Here, of course, i t must be r e a l i z e d that a Return on Investment concept i n the sense of P r o f i t cannot be a p p l i e d . However, the p r i n c i p l e s of sound sys t e m a t i c programming of c a p i t a l e x p e n d i t u r e s , and sound investment of taxpayer's money should and must be of utmost concern to a c i t y manage-ment. Another r e c e n t a p p l i c a t i o n of the p r i n c i p l e s of Return on Investment can be found i n the s t u d i e s of the Royal Commission on P r i c e Spreads. The Royal Commission a p p l i e d s e v e r a l c r i t e r i a i n t h e i r e f f o r t s to assess the spread between farm p r i c e s and r e t a i l p r i c e s , and to attempt to determine whether t h i s spread was f a i r and reasonable, or e x c e s s i v e . ^ A f t e r ap-proaching the problem from s e v e r a l d i f f e r e n t a n g l e s , the Commission adopted the Rate of Return 18 Report of the Royal. Commission on P r i c e Spreads of Pood Products, (Ottawa, Queen's P r i n t e r , September, 1959), V o l . I, pp. 27-46. - 67 -on Investment as i t s standard. I t must be noted, however, that "investment" i n t h i s study was de-f i n e d to mean "s h a r e h o l d e r ' s e q u i t y " i n s t e a d of t o t a l investment or " c a p i t a l employed". While the r e s u l t s obtained may have been s a t i s f a c t o r y f o r the purposes of the study, the d e f i n i t i o n of "investment" as " c a p i t a l employed" would have g i v e n a more accurate i n d i c a t i o n of the p r o f i t -a b i l i t y of the concerns under study. The a p p l i c a t i o n of a q u a n t i t a t i v e e v a l u a t i o n standard by an i n d i v i d u a l i n v e s t o r s e e k i n g to u t i l i z e h i s savings i n the most e f f e c -t i v e manner was examined. In t h i s i n s t a n c e the a l t e r n a t i v e s under c o n s i d e r a t i o n were f u r t h e r i n -vestments i n commercial r e a l e s t a t e , r e s i d e n t i a l r e a l e s t a t e , or the s e c u r i t y market. The amount of funds was small but i t would seem that these p r i n c i p l e s should be a p p l i e d i f they have the m e r i t claimed f o r them. I t oan r e a d i l y be seen from the examples p r e v i o u s l y g i v e n that a l t e r n a t i v e i n v e s t -ment p r o p o s a l s can be evaluated by a p p l y i n g the r e t u r n on investment c r i t e r i o n . However, the f a c t o r of r i s k can not be q u a n t i t a t i v e l y expressed. - 68 -As a r e s u l t i t must be concluded that r a t e of r e t u r n c a l c u l a t i o n s , w h i l e a v a l u a b l e a i d to making a sound d e c i s i o n , cannot e l i m i n a t e the n e c e s s i t y of good judgment. The a p p l i c a t i o n of the c a p i t a l budget^-ing concept was examined i n the a i r l i n e i n d u s t r y and i n p a r t i c u l a r w i t h r e f e r e n c e to one major i n t e r n a t i o n a l a i r l i n e w i t h over 13,000,000 r e v -enue m i l e s i n 1959. The i n f o r m a t i o n obtained was based on p e r s o n a l i n t e r v i e w s w i t h a s e n i o r exeoutive of the company. In g e n e r a l , i t may be concluded that the r e t u r n on investment con-cept w h i l e very d e s i r a b l e i s not e x t e n s i v e l y used. One of the main reasons g i v e n f o r t h i s laok of use i s t h a t the i n d u s t r y has been f a c e d w i t h very r a p i d t e c h n o l o g i c a l change i n the y e a r s since World War I I . The a i r l i n e s are i n v o l v e d i n i n t e n s e c o m p e t i t i o n , and t h e i r primary em-! p h a s i s has been to keep pace w i t h t e c h n o l o g i c a l change, and competive and customer demand. In these circumstances, payback w i t h i t s emphasis on near-year earnings has been used to a g r e a t e r extent than r e t u r n on investment. Por example, - 69 r i n purchasing a Super C o n s t e l l a t i o n a i r c r a f t f o r two m i l l i o n d o l l a r s i n 1954, a company would have to r e a l i z e that by 1959-1961 j e t powered a i r c r a f t would be a v a i l a b l e and i n use i n commercial a i r t r a n s p o r t . As a r e s u l t , although the economic l i f e of the asset might be ten years, a l l c a l c u l a t i o n s of r e t u r n on investment would have to be based on f i v e to seven years. At the end of f i v e to seven years the a i r c r a f t may w e l l continue i n use, but not i n f i r s t c l a s s passenger s e r v i c e . I t w i l l be leased out, s o l d , or used i n f r e i g h t ( a i r - c a r g o ) s e r v i c e . In such u n c e r t a i n c o n d i t i o n s , the company may w e l l have to be s a t i s f i e d w i t h a payback r e t u r n i n s t e a d of a long term p r o f i t . The long run r e t u r n on investment w i l l be sac-? r i f i c e d to keep or e s t a b l i s h a p o s i t i o n i n the t o t a l market. To have refused the investment on the grounds of an inadequate r e t u r n on investment would have meant the l o s s of a p o s i t i o n i n the competitive market. A l e v 6 l payback w i t h no annual p r o f i t might w e l l have to be accepted as « 70 -a temporary expendient under uncertain technological conditions. In the case of the major airline whose approach to this problem was examined in more detail, i t was found that the broad concept of capital budgeting, as outlined in this thesis, was being ut i l i z e d . Its value was acknowledged by the executives interviewed. The demand for capital i s determined at periodic intervals and capital budget proposals are submitted. The cost and supply of capital are handled together and are indirectly a factor in the decision, within the limits of the market and competitive situation outlined earlier. Budget proposals are on a total project basis, that i s , service and subsidiary equipment are included in the total appropriation, and as long as that total is not exceeded, no further reference to the budget authority i s required. To reduce the demands for oapital outlay, extensive use of leasing i s made. This practice also assists with the problems out-lined previously of keeping pace with the comr petitive situation by reducing the amount of - 71 -c a p i t a l I n f l e x i b l y committed f o r long p e r i o d s . In t h i s i n d u s t r y p o s t p o n a b i l i t y as a c r i t e r i o n has a val u a b l e s e r v i c e to perform. I f an investment i n a i r c r a f t can be postponed, a b e t t e r r e t u r n on the investment i n e x i s t i n g a s s e t s can be r e a l i z e d . P o s t p o n a b i l i t y i s exe r c i s e d to the l i m i t s imposed by competitive circumstances and market demand. I f post-p o n a b i l i t y cannot be a p p l i e d , and the i n v e s t -ment deemed necessary f o r the reasons c i t e d , the proposal w i l l then be examined from the standpoint of payback. I f the investment promises a payback w i t h i n the estimated time a v a i l a b l e before the next advance i n t h i s r a p i d -l y changing Industry, the proposal w i l l probably be given approval. I t was st a t e d by the exec-u t i v e s interviewed that they recognized that these c r i t e r i a w i l l not s u f f i c e f o r the f u t u r e . The i n d u s t r y i s e n t e r i n g a new phase. With the advent of j e t t r a v e l I t appears that no major t e c h n o l o g i c a l change i n a i r c r a f t w i l l be expect-ed f o r approximately ten years. This length of time i s being used f o r e v a l u a t i o n of investments - 72 -i n j e t a i r c r a f t . A r e t u r n on investment c r i t e r -i o n w i l l become i n c r e a s i n g l y u s e f u l i n the years ahead. With a i n d u s t r y that i s g r a d u a l l y stab-i l i z i n g but yet remaining f i e r c e l y competitive, management w i l l be forced to examine more c r i t i c -a l l y and o b j e c t i v e l y a l l c a p i t a l expenditure pro-p o s a l s . Under these c o n d i t i o n s an e v a l u a t i o n y a r d s t i c k that i s accurate, i n c l u s i v e , r e a l i s t i c , and v e r s a t i l e , w i l l be of the utmost value as an a i d to d e c i s i o n . P o s t p o n a b i l i t y and payback can-not meet these requirements. The r e t u r n on i n v e s t -ment approach i s the best method of e v a l u a t i o n a v a i l a b l e f o r t h i s purpose, and w i l l merit more c o n s i d e r a t i o n i n the fu t u r e than has been accorded i t i n the past. An examination was a l s o made of two p u b l i c u t i l i t i e s . The large scale expenditures of t h i s type of e n t e r p r i s e appear to lend them-selves admirably to the use of the r e t u r n on i n -vestment concept. One of these companies was a telephone u t i l i t y w i t h a s s e t s i n excess of #200, 000,000, which i s regulated by the Board of Transport of the Federal government. The concepts - 73 -of sound c a p i t a l budgeting are r e c e i v i n g c a r e f u l a t t e n t i o n . Expenditure f o r e c a s t s are prepared on a y e a r l y b a s i s w i t h long range planning being developed on a continuous b a s i s f o r a twenty year f u t u r e p e r i o d . A r e t u r n on investment i n the sense of p r o f i t cannot be a p p l i e d here due to the method of r e g u l a t i o n . Regulation, through rate s t r u c t u r e , i s done on the b a s i s of s e t t i n g r a t e s covering a l l costs w i t h an a l l o w e d . c o n t r i b u t i o n to s u r p l u s . I n t h i s approach dividends assume the same s t a t u s as i n t e r e s t charges and are taken as a cost of money. In other words, the amount of p r o f i t allowed over and above t o t a l defined costs i s very s m a l l . Nevertheless, c a r e f u l e v a l u a t i o n and a n a l y s i s i s r e q u i r e d , as the margin a v a i l -able to cover unforeseen cos t s i s n e g l i g i b l e . W i t h i n t h i s framework, payback becomes of prime importance. Any c a p i t a l expenditure w i l l be subjected to e v a l u a t i o n on the b a s i s of oovering a l l costs over the u s e f u l l i f e of the ass e t . I t must be remembered that ' c o s t s ' , as defined f o r t h i s purpose, in c l u d e the cost of - 74 -dividends. Postponability i s also used to some extent i n determining p r i o r i t y of expendi-tures, i n the l i g h t of the conditions of supply of c a p i t a l . Normally p r i o r i t y would be deter-mined on a rate of return scale, but with t h i s factor fixed and rates regulated, the choice of alternatives i s eliminated on a l l grounds but that of postponability. Under these conditions, the supply of c a p i t a l w i l l be r e s t r i c t e d to external sourees. Operating with regulated additions to surplus, and i n e f f e c t regulated dividends, and i n view of a ninety percent payout of earnings i n dividends, i t can be seen that retained earnings cannot be of any material assistance i n financing future expansion. A further complication a r i s e s , i n that depreciation i s allowed only on the basis of o r i g i n a l cost. Due to a long period of continuous i n f l a t i o n , depreciation allowances retained for replacement of assets are inadequate. Hence, even to maintain the asset structure of the enterprise, new external finanoing must be sought. It would appear that t h i s practise requires a newer, more - 75 -r e a l i s t i c approach, e i t h e r through more l i b e r a l " c o s t " allowances f o r d e p r e c i a t i o n (replacement cost method), or through a l l o w i n g a gr e a t e r mar-g i n of r e t a i n e d earnings to o f f s e t the e f f e c t s of inadequate d e p r e c i a t i o n based on h i s t o r i c a l c o s t s . Another aspect that m e r i t s a t t e n t i o n w i t h i n the framework of c a p i t a l budgeting i n t h i s telephone u t i l i t y , i s the use of a revenue r e -quirements concept. This i s best defined by the question w i l l the expenditure produce s u f f i c i e n t revenue to support the ou t l a y now? Telephone s e r v i c e i s based on peak load demand during "busy hour" p e r i o d s . This i s the r e s u l t of business lo a d . R e s i d e n t i a l load i s sought to l e v e l out the peak and produce more off-peak revenue. This con-cept may be i l l u s t r a t e d by an example. In Pigure A, GX represents e x i s t i n g trunk c a p a c i t y (trunk c a p a c i t y i s inter-exehange c a p a c i t y ) , OC i s the amount pr e s e n t l y i n peak load use. XY i s a pro-posed extension. However, peak load t r a f f i c w i l l not provide s u f f i c i e n t revenue to support t h i s e xtension. OB i s e x i s t i n g r e s i d e n t i a l l o a d . Some a c t i o n i s req u i r e d as CX i s i n s u f f i c i e n t s a fety - 76 -c a p a c i t y , and some exte n s i o n i s r e q u i r e d . Next a s a t u r a t i o n survey i s conducted to determine the t o t a l off-peak t h e o r e t i c a l market a v a i l a b l e . T h i s i s r e p r e s e n t e d by GD (or ED i s the a d d i t i o n a l l o a d t h e o r e t -i c a l l y a v a i l a b l e ) . Therefore the expendi-ture can be j u s t i f i e d i f s a l e s can s a t u r a t e o f f - p e a k market up to X and peak l o a d to D, l e a v i n g DY as uncommitted c a p a c i t y . FIGURE A 3 0 A CrtPAc i-ry - 77 -Here i s another application of c a p i t a l budgeting concepts, but there emerges once again a series of unknowns that are d i f -f i c u l t to reduce to formula expression. E l e c t r i c i t y and gas u t i l i t i e s may also f i n d merit i n the c a p i t a l budgeting con-cepts. The i n s t a l l a t i o n of plant, d i s t r i b u t i o n l i n e s , and the alternative ways of generating power appear to be natural areas for ap p l i c a t i o n of these methods. Capital budgeting procedures are being used, but once again, c r i t e r i a f o r measurement and evaluation are payback and post-ponability much more frequently than return on investment. Postponability r e s u l t s from an ex-pediency approach of doing the minimum at a given time, and attempting to keep pace with an ever-growing market demand. In times of rapid expan-sion and great demand for money, those projects which can be postponed usually are. Payback i s applied to those projects which are seriously considered and i t appears that as long as a project shows a reasonable prospect of being paid out over an a r b i t r a r i l y set period of time, i t - 78 -w i l l be proceeded with. L i t t l e attention seems to be directed to future earnings return a f t e r the payout period. One major group of companies with assets i n excess of f170,000,000 however, has an excellent long term expenditure plan, and does i n fact apply quite rigorous standards of minimum return on investment as a factor i n evaluating a l l expenditure proposals. It was observed that the objective evaluation on a rate of return basis was regarded as a s i g n i f i c a n t faotor i n evaluation but was only part of the t o t a l evaluation which included many subjeotive and q u a l i t a t i v e considerations. Next manufacturing industries, both primary and secondary, were examined. Here again, the greatest emphasis was placed on pay-baek. In one company studied, a r b i t r a r y rates had been set that small investments of |5,000 or less must meet a one year payback standard. Larger investments were required to pay back over a three to f i v e year period. No upper l i m i t was formally set but i n general a l i m i t of $50,000 was recognized. Expenditures involving larger - 79 -amounts than t h i s were e x t e n s i v e l y examined and a minimum r e t u r n on investment ( c a p i t a l employed) was s e t . This minimum was based on management's judgment and included considera-t i o n of the cost of money, r i s k i n v o l v e d , and the rate of r e t u r n being r e a l i z e d i n the prim-ary l i n e of operations being conduoted. This company a l s o recognized the p o s s i b i l i t y of using a r a t e of r e t u r n a n a l y s i s on such i n -t a n g i b l e s as i n - p l a n t t r a i n i n g of standby work-f o r c e . In t h i s instance the cost of t r a i n i n g can be evaluated i n the l i g h t of increased c o s t s that would r e s u l t i f an operation had to be shut down or reduced i n speed because of the l a c k of a t r a i n e d replacement. Among the companies s t u d i e d , t h i s was the most extensive use found of the r a t e of r e t u r n concept. I t can be seen that here too, there i s a s u b s t a n t i a l preoccupa-t i o n w i t h payback as a c r i t e r i o n . A l l other manufacturing companies con-s u l t e d , i n d i c a t e d s i m i l a r procedures. In most cases there i s greatest a t t e n t i o n and weight given the paybaek approach. In another case of - 80 -a primary metals r e f i n i n g operation, r e t u r n on investment was used i n the o r i g i n a l p l a n t study but present a d d i t i o n s , changes and im-provements are being judged on an a r b i t r a r y payback b a s i s . The reasons and circumstances surrounding t h i s emphasis on the c r i t e r i a of p o s t p o n a b i l i t y and payback and the lack of c o n s i d e r a t i o n of the t h e o r e t i c a l l y sounder r e t u r n on investment c r i t e r i o n w i l l be ex-amined i n the chapter which f o l l o w s . CHAPTER X EVALUATION OP THE SURVEY In c o n s i d e r i n g the survey of p r a c t i c e o u t l i n e d i n the p r e v i o u s chapter i t w i l l be h e l p -f u l i f the ten components of a c a p i t a l management program r e f e r r e d to p r e v i o u s l y are used as a b a s i s . 1 9 1. c r e a t i v e search f o r p r o f i t a b l e o p p o r t u n i t i e s 2. long range c a p i t a l p lans 3. shor t range c a p i t a l budget 4. measurement of p r o f i t worth 5. s c r e e n i n g and s e l e c t i o n 6. c o n t r o l of a u t h o r i z e d o u t l a y s 7. post mortems 8. r e t i r e m e n t and d i s p o s a l 9. forms and procedures 10. economies of c a p i t a l budgeting The c a p i t a l management program that embraces these p o i n t s has adopted the concept of o a p i t a l budget-i n g . The degree of p r e c i s i o n and comprehensiveness used to meet the requirements of each of the com-ponents w i l l determine the e f f e c t i v e n e s s of the c a p i t a l management program. 19 J o e l Dean, "Measuring the P r o d u c t i v i t y of C a p i t a l " , op. c i t . . p. 122. - 88 -The o v e r a l l concept of c a p i t a l budget-i n g i s being g e n e r a l l y a p p l i e d i n a l l oases ex-amined. C a p i t a l budgeting as a frame of r e f e r e n c e , has found c o n s i d e r a b l e support from management. However, the extent of a p p l i c a t i o n , the i n t e r p -r e t a t i o n of the components, and the we i g h t i n g attached to each, vary s i g n i f i c a n t l y . o CREATIVE SEARCH FOR. PROFITABLE OPPORTUNITIES Few w i l l deny the v a l i d i t y of t h i s p o i n t as the f i r s t step of a sound c a p i t a l program. A l l f i r m s reoognize the need to keep pace w i t h our expanding economy and t e c h n o l o g i c a l change. As a r e s u l t the ast u t e b u s i n e s s e x e c u t i v e must be ever on the watch f o r new o p p o r t u n i t i e s . The h e a l t h of a b u s i n e s s o p e r a t i o n r e q u i r e s p r o f i t ; p r o f i t i n the broad sense i s r e a l i z i n g an increment of g a i n over and above e f f o r t expended. Without p r o f i t s there i s no reward to the business a c t i v i t y , and the reward i s e s s e n t i a l to keep the process s e l f -g e n e r a t i n g . S e l f - g e n e r a t i o n i s the process which induces expansion and improvement. - 83 -LONG RANGE CAPITAL PLANS Long range c a p i t a l p lans provide the 'terms of r e f e r e n c e 1 which i n f l u e n c e a company's p o l i c i e s and g o a l s . I f a f i r m has sought out a p r o f i t a b l e o p p o r t u n i t y , i t must e s t a b l i s h a p l a n to reach t h i s o b j e c t i v e , and implement the idea i n order to r e a l i z e the p r o f i t s d e s i r e d . I n d i v i d -u a l p r o j e c t s should f i t w i t h i n these broad l i n e s . Here again, the merit of t h i s p o i n t i s r e a d i l y acknowledged by the p r a c t i s i n g b u s i n e s s -man. However, p r a c t i c e does not always conform to theory and examples of " l i p - s e r v i c e " only, can be found. T h i s a r i s e s as a r e s u l t of inadequate d e f i n i t i o n of long range g o a l s . Firms and i n d i v i d -u a l s o f t e n proceed on a day to day b a s i s of meeting e x p e d i e n c i e s as they o c c u r . As a r e s u l t , departure from, or break-down of the c a p i t a l budgeting concept may be found at t h i s stage. I f so, i t w i l l not be p o s s i b l e to re a c h sound c a p i t a l expenditure d e c i s i o n s because broad guide l i n e s of p o l i c y w i l l be l a c k i n g . However, i n the companies examined d u r i n g the course of t h i s study, long range p l a n n i n g was being e f f e c t -i v e l y and a c t i v e l y c a r r i e d out i n most cases. - 84 -SHORT RANGE CAPITAL BUDGET As pointed out e a r l i e r i n t h i s study, the l i s t i n g of a p r o j e c t on a y e a r l y c a p i t a l budget i n d i c a t e s only that i t i s regarded as worthy of d e t a i l e d study f o r that year. Here, a ser i o u s breakdown i n p r a o t i c e occurs. Often, i f a p r o j e c t passes some p r e l i m i n a r y t e s t and reaches the stage of being l i s t e d pn the short term ( y e a r l y ) budget, i t i s assumed that the p r o j e c t w i l l be implemented. An example of t h i s occurred i n one company, where at t h i s stage, a re s p o n s i b l e exec-u t i v e c a l l e d f o r tenders f o r c o n s t r u c t i o n of the pr o j e c t and opened n e g o t i a t i o n s f o r the necessary land and u t i l i t y s e r v i c e s . He was somewhat emba-rr a s s e d , and h i s company put to considerable ex-pense, when the p r o j e c t was c a l l e d o f f and struck from the budget f o r that year. This component of the t o t a l program i s the stage, covered e a r l i e r i n the paper, where departments or d i v i s i o n s submit proposals f o r de-t a i l e d study by the budget committee. Probably i t would be more appropriate to r e f e r to t h i s stage by the term "short term c a p i t a l expenditure proposals". - 85 -MEASUREMENT OP PROJECT WORTH This i s the aspect of c a p i t a l budget-i n g to which much of the l i t e r a t u r e i n r e c e n t y e a r s has been d i r e c t e d . The advantages and disadvantages of the major approaches to measure-ment have been debated at great l e n g t h . The b a s i s or e s s e n t i a l f e a t u r e s of the three major apr proaches have been summarized e a r l i e r i n t h i s study and need not be repeated here. In theory, there seems l i t t l e doubt that some form of a r e t u r n on investment approach i s much s u p e r i o r to the c o a r s e r screens of p o s t p o n a b i l i t y and pay-back. In p r a c t i c e , r e t u r n on investment does not have the currency i t would appear to deserve. Payback, i n s p i t e of i t s shortcomings, i s much more e x t e n s i v e l y used. N e v e r t h e l e s s , some attempt at measurement, however inadequate, i s being made and thus the concept of c a p i t a l budgeting i s being f o l l o w e d . SCREENING AND SELECTION T h i s component i n v o l v e s the comparison of a proposed investment w i t h o t h e r p r o j e c t s i n 86 -the l i g h t of c a p i t a l a v a i l a b l e , the cost of that c a p i t a l , the a t t r a c t i v e n e s s of a l t e r n a t i v e i n v e s t -ments, and the r e s u l t s of the measurement t e s t covered above. I t i s s i g n i f i c a n t that quite d i f -f e r e n t r e s u l t s can be obtained on the same pro-j e c t i f payback r a t h e r than r e t u r n on investment i s used as a c r i t e r i o n f o r measurement. Thus, the p r i o r i t y or ranking a r r i v e d at i n the screen-in g and s e l e c t i o n process might be q u i t e d i f f e r e n t under the two methods, and the r e s u l t i n g d e c i s i o n s quite erroneous i n the l i g h t of the f i r s t compon-ent, p r o f i t a b l e o p p o r t u n i t i e s . P r o j e c t s that meet or pass the screen-ing and s e l e c t i o n process are i n e f f e c t approved f o r implementation. She remaining steps i n the c a p i t a l program are based on executing the p l a n approved at t h i s stage. This study has been con-cerned p r i m a r i l y w i t h the f i r s t f i v e of the compon-ents, but of course, a l l being i n t e r g a l p a r t s of the t o t a l program they must be considered i n the context of the whole program. This component of screening and s e l e c t i o n i s the most important aspect, f o r at t h i s stage - 87 -management must commit i t s e l f to a f i r m d e c i s i o n . Herein l i e s that great danger, mentioned e a r l i e r , of p l a c i n g sole r e l i a n c e on q u a n t i t a t i v e assess-ments. Even i f the best a v a i l a b l e c r i t e r i o n i s used, i t i s only as accurate as the assumptions made i n the c a l c u l a t i o n . Furthermore, c e r t a i n f a c t o r s such as r i s k cannot be introduced to the c a l c u l a t i o n s and cannot be reduced to a s i n g l e f i g u r e . Hence, i t must be r e i t e r a t e d that quant-i t a t i v e measurement de v i c e s , while a v a l u a b l e a i d , cannot be a s u b s t i t u t e f o r management's judgment. Judgment i s a very l a r g e p a r t , i f not the l a r g e s t part of the f i n a l s e l e c t i o n process. The f i n d i n g s already reported i n d i c a t e t h a t , i n a c t u a l p r a c t i s e , judgment forms most i f not a l l the b a s i s f o r d e c i s i o n . Because the r e -finement of technique, expressed through the r e t u r n on investment approach to measurement, has not been widely accepted, management i n these s i t u a t i o n s has l i t t l e or no q u a n t i t a t i v e a i d s to supplement judgment i n reaching a s e l e c t i o n d e c i s i o n . Screen-i n g and s e l e c t i o n must be a p a r t of any c a p i t a l investment d e c i s i o n and i t s i n c l u s i o n i n our l i s t - 88 -of components i s t h e r e f o r e automatic. The p o i n t to be emphasized i s that a sound quant-i t a t i v e approach to c a p i t a l budgeting w i l l g r e a t l y f a c i l i t a t e wise s e l e c t i o n . I t i s t h i s f e a t u r e of s e l e c t i o n pro-cedure that appears to be very much l a c k i n g i n the p r a c t i c e of the companies examined. The major o b j e c t i o n to the use of r e t u r n on investment c a l c u l a t i o n s should be r e c o g n i z e d . I t i s argued that t h i s approach a p p l i e s a very p r e c i s e formula to some very im-p r e c i s e assumptions. The cost of a p r o j e c t , i t s u s e f u l economic l i f e , the a p p r o p r i a t e i n t e r e s t r a t e and the p r o f i t s or earn i n g s r e s u l t i n g from the investment are at best only e s t i m a t e s . Hence while the RGI c a l c u l a t i o n i m p l i e s a very accurate a p p r a i s a l , i n f a c t the c o n c l u s i o n based on i t might be q u i t e erroneous. The u n c e r t a i n t y of any q u a n t i t a t i v e e v a l u a t i o n developed thus f a r i s i t s g r e a t e s t weakness. However, i n r e p l y i t may be s a i d that while t h i s weakness i s acknowledged, the ROI c a l c u l a t i o n i s the most r e f i n e d , accurate technique a v a i l a b l e . I t s advantages i n preference - 89 -to l e s s a c c u r a t e techniques or no q u a n t i t a t i v e e v a l u a t i o n at a l l would seem to j u s t i f y i t s i n c l u s i o n as a v a l u a b l e component i n the c a p i t a l management program. IMPLEMENTATION OF THE DECISION The remaining f i v e components of the c a p i t a l management program can be grouped under the above heading of implementation. C o n t r o l of a u t h o r i z e d o u t l a y s i n v o l v e s a system of budget c o n t r o l and comparison. Post mortems r e f e r s to reassessment and r e a p p r a i s a l of both cost and earnings a f t e r the p r o j e c t has been completed and p l a c e d i n o p e r a t i o n . Retirement and d i s p o s a l . Management 1s r e s p o n s i b i l i t y ends only when the a s s e t i s r e t i r e d and a s u i t a b l e source of a c t -i o n planned (e.g. a new c a p i t a l p r o j e c t s e l e c t e d ) . Forms and procedures are a necessary nuisance to any smooth o p e r a t i o n . Economics of c a p i t a l budgeting r e f e r s to management's keeping abreast of develop-- 90 -ments i n current eoonomic t h i n k i n g which may i n f l u e n c e g r e a t l y f u t u r e courses of a c t i o n . In the s t u d i e s undertaken these f i v e components were being u t i l i z e d . Post mortems appeared l a r g e l y by a c c i d e n t , however, and were seldom co n s c i o u s l y sought. Great emphasis was found on budget c o n t r o l . Forms and procedures which, while necessary, are somewhat mechanical f u n c t i o n s of the program and should not receive excessive a t t e n t i o n . The economics of c a p i t a l budgeting i s r e c e i v i n g quite d e t a i l e d and i n t e n -s i v e study by many exe c u t i v e s . A r e a l i z a t i o n was evidenced that the era of generous p r o f i t margins and s e l l e r ' s markets that has been a c h a r a c t e r i s t i c of much of the post war period has ended. S u r v i v a l i n an i n c r e a s i n g l y competitive economy demands enlightened and aggressive manage-ment a c t i v e l y seeking a l l the i n f o r m a t i o n a v a i l -a b l e . A p p l i c a t i o n of t h i s i n f o r m a t i o n as a t o o l i n d e c i s i o n making, as has been pointed out, s t i l l l eaves something to be d e s i r e d . CHAPTER XI CONCLUSIONS The concept of c a p i t a l budgeting has been examined, and some of the f a c t o r s that are included i n a c a p i t a l management program have been o u t l i n e d . Through the examination of a c t u a l p r a c t i c e , an attempt has been made to assess the s i g n i f i c a n c e of these concepts i n a p p l i e d d e c i s i o n s . The examination of p r a c t i c e was based on four questions: 1. Are the p r i n c i p l e s of c a p i t a l budgeting being applied? 2. I f they are, what i s t h e i r value to management? 3. I f they are not, what concepts and c r i t e r i a , i f any, are being used? 4. Can these p r i n c i p l e s be a p p l i e d to c a p i t a l management d e c i s i o n s w i t h r e s u l t a n t value to the ad-m i n i s t r a t o r ? - 92 The p r i n c i p l e s of c a p i t a l budgeting are being a p p l i e d i n those companies and i n -d u s t r i e s examined. Management acknowledges t h e i r importance yet seems to place too l i t t l e weight on them i n the d e c i s i o n making process. In the area of measurement and e v a l u a t i o n of p r o j e c t s , the c r i t e r i a used i n some cases are not s u f f i c i e n t l y s e n s i t i v e to give good quant-i t a t i v e assessments. The use of a r e t u r n on investment formula would g r e a t l y improve t h i s e v a l u a t i o n . The p r i n c i p l e s of a sound c a p i t a l management program are, i n gene r a l , being f o l -lowed and are m a t e r i a l l y a i d i n g management i n reaching sound expenditure d e c i s i o n s . However, the r e s u l t s of c a l c u l a t i o n s are only as v a l i d and accurate as the f a c t o r s which are used i n the c a l c u l a t i o n . In a d d i t i o n , i t must again, be cautioned, not a l l f a c t o r s can be expressed q u a n t i t a t i v e l y . The s u b j e c t i v e areas r e q u i r i n g the e x e r c i s e of sound judgment loom very large i n any c a p i t a l expenditure d e c i s i o n . BIBLIOGRAPHY BIBLIOGRAPHY A. BOOKS: Dean, J o e l . C a p i t a l Budgeting, New York, Columbia U n i v e r s i t y P r e s s , 1951. A g e n e r a l survey of the p r i n c i p l e s of c a p i t a l budgeting and some of the f a c t o r s that should be considered i n making c a p i t a l investments. Edge, C.G. The A p p r a i s a l of C a p i t a l Expen- d i t u r e , S o c i e t y of I n d u s t r i a l and Cost Accountants, December, 1959. A survey of the methodology used i n the d i s c o u n t methods of measuring r e t u r n on investment. 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"Measuring the P r o d u c t i v i t y of C a p i t a l " , Harvard Business Review, January/February, 1954, pp. 120-130. . "Measurement of Return on C a p i t a l Employed", Cost and Management, J u l y / August, 1959, pp. 80-89. " P r o f i t a b i l i t y Index f o r C a p i t a l Investment", C o n t r o l l e r , February,. 1958, pp. 64-68. Advocating the use of. a p r o d u c t i v i t y c r i t e r i o n i n measurement of r e t u r n on i n v e s t -ment. Proposes guide l i n e s to determine worth of v a r i o u s c r i t e r i a i n use and p r e s e n t s s t r o n g arguments f o r a d i s c o u n t e d (present worth) method of measurement as one which best s a t -i s f i e s a l l requirements. Dobrovolsky, S.P. "Economics of Corporate I n t e r n a l and E x t e r n a l F i n a n c i n g " , J o u r n a l of Finance, March, 1958, pp. 323-325. A d i s c u s s i o n of the a f f e c t s of d i v i d e n d p o l i c y on f i n a n c i n g requirements and the l e v e l of savings a v a i l a b l e f o r investment i n corp-orate expansion. Arguments f o r r e t a i n e d earn-ings as a necessary p a r t of f i n a n c i n g expansion. - 96 -Eokelamp, G.H. "Budget i s Keystone of Management Pla n n i n g " , O f f i c e , January, 1958, pp. 126-128. P o i n t s out the need f o r systematic budget-i n g as a key t o o l i n p l a n n i n g f o r f u t u r e needs. Edson, H.O. "ROI as a Measure of Management E f f i c i e n c y " , C o n t r o l l e r , June, 1957, pp. 271-278. Shows d e r i v a t i o n of b a s i c RGI formula and the r e l a t i o n s h i p of important f a c t o r s which a f f e c t r e s u l t a n t c a l c u l a t i o n . . " S e t t i n g a Standard f o r Your Company's Return on Investment", C o n t r o l l e r , September, 1958, pp. 473-481. Advocates the d e t e r m i n a t i o n of a minimum r a t e of r e t u r n , b y which to judge and evaluate expenditure p r o p o s a l s . Freund, W.C. "An A p p r a i s a l . o f the Sources and Use of Funds", J o u r n a l of Finance, May, 1958, pp. 467*475. A development of work known as "Source and U s e s i o f Investment Funds", which i s an a n a l y s i s of the c a p i t a l market. Attempts to analyze e f f e o t of i n t e r e s t r a t e changes. Griswold, J.A. "More f o r Your C a p i t a l D o l l a r " , C o n t r o l l e r , October, 1957, pp. 480-486. An a r t i c l e i n d i c a t i n g u s e f u l n e s s of r e -turn on investment concept and i l l u s t r a t i n g that i t i s not as d i f f i c u l t to apply as pop* u l a r i l y b e l i e v e d . Includes d e f i n i t i o n s and procedure to use i n d i s c o u n t i n g . Hienman, S.F. "Basing C a p i t a l Outlays on ROI", N.A.C.A. B u l l e t i n , A p r i l , 1957. F u r t h e r advocacy of use of r e t u r n on investment concept. - 97 -H i r s c h l i e f e r , J . "On the Theory of Optimal Investment D e c i s i o n " , J o u r n a l of  P o l i t i c a l Economy. August, 1958, pp. 329-352. An argument f o r g r e a t e r a t t e n t i o n to f a c t o r s i n the economy and i n p a r t i c u l a r i n t e r e s t r a t e s when c o n s i d e r i n g investment d e c i s i o n s . Kooh, E.G. "Use of Management Y a r d s t i c k f o r C a p i t a l E x p e n d i t u r e s D e c i s i o n s " , C o n t r o l l e r , January, 1958, pp. 19-25. A comparison of s e v e r a l of the y a r d -s t i c k s oommonly i n use and t h e i r e f f e c t i v e n e s s . Lundin, O.A. " J u s t i f y i n g C a p i t a l E xpenditures, Before and A f t e r " , N.A.O.A. B u l l e t i n , J u l y , 1956, pp. 372-385. A system of c o n t r o l which r e q u i r e s sub-s t a n t i a t i o n of proposed expenditures before a p p r o v a l coupled w i t h a r e - a p p r a i s a l of r e s u l t s a f t e r completion. McLean, J.C. "How to E v a l u a t e New C a p i t a l I nvest-ments", Harvard Business Review, Nov,ember/December, 1958, pp. 59-64. Examines why ROI i s best form of measure-ment; why d i s c o u n t e d cash flow i s best form of ROI; and what techniques a i d i n the use of ROI. Margison, J.E. "Have you a Planned Program f o r P l a n t Growth?", I n d u s t r i a l Canada, June, 1957, pp. 94-96. Advocates c o n s i d e r a t i o n of c a p i t a l budget-i n g . Matthews, John B., J r . "How to A d m i n i s t e r C a p i t a l Spending", Harvard B u s i n e s s Review, March/ A p r i l , 1959, pp. 87-93. P o i n t s out d e s i r a b i l i t y of u s i n g sound a n a l y t i c a l techniques and the need f o r thorough - 98 -understanding of the techniques i n use. Emphasizes importance of c a p i t a l spending to top management. M o l l e r , G. "Try Budgeting f o r Return on C a p i t a l Employed", C o n t r o l l e r . February, 1958, pp. 107-110. Urges use of c a p i t a l employed i n s t e a d of c a p i t a l i n v e s t e d as denominator i n r e t u r n on investment c a l c u l a t i o n s . Development of ROI formula based on margin on s a l e s and t u r n -over of c a p i t a l employed. Moore, T.F. " C a p i t a l F i n a n c i n g f o r a Growth Program", Canadian C h a r t e r e d Accountant, Maroh, 1958, pp. 201-207. The importance of sound p l a n n i n g to continued growth i s re-emphasized. Report o f the F e d e r a l Trade Commission on Rates  of Return f o r I d e n t i c a l Companies i n S e l e c t e d Manufacturing I n d u s t r i e s , ~ 9 4 0 -1947-1957, Ottawa, Dominion Bureau of S t a t i s t i c s , 1959. S t a t i s t i c a l c o m p i l a t i o n . "Return on C a p i t a l as a Guide to Management D e c i s i o n s " , N.A.A. Research Report Number 35, N.A.A. B u l l e t i n , December, 1959. A survey of theory and p r a c t i s e i n f i f t y -f o u r companies d e a l i n g p r i m a r i l y w i t h methods i n use. Reul, Ray I. " P r o f i t a b i l i t y Index f o r Investments", Harvard B u s i n e s s Review, July/August, 1957 pp. 116-132. A p r o p o s a l f o r an index which i n c l u d e s a l l f a c t o r s i n c a p i t a l d e c i s i o n except r i s k which must remain a f a c t o r of judgment. - 99 -Robbins, S., and F o s t e r , E., J r . " P r o f i t P l a n -n i n g and the Finance F u n c t i o n " , J o u r n a l  of Finance. December, 1957, pp. 894-901. Emergence of the c o n t r o l l e r s h i p f u n c t i o n ; the concern w i t h cash; the use of break-even a n a l y s i s , d i r e c t c o s t i n g and f l e x i b l e budgets as t o o l s of p r o f i t p l a n n i n g . Seney, W.T. "Hazards i n the Cost of C a p i t a l Form-u l a " , Budgeting, F o r e c a s t i n g , and Return  on Investment, C o n t r o l l e r ' s I n s t i t u t e of America, A p r i l , 1956. A c a u t i o n a g a i n s t o v e r s i m p l i f i e d and i n -d i s c r i m i n a t e use of ROI formulae. S h i l l i n g l a w , G. "Guide to I n t e r n a l P r o f i t Measure-ment", Harvard Business Review, Maroh/ A p r i l , 1957, pp. 38-46. Development and use of v a r i o u s p r o f i t measurements f o r i n t e r n a l c o n t r o l and e v a l u a t i o n . Solomon, E. "The A r i t h m e t i c of C a p i t a l Budgeting D e c i s i o n s " , J o u r n a l of B u s i n e s s , A p r i l , 1956, pp.-124-129. The c o n s t r u c t i o n of ROI formulae. , . "Measuring a Company's Cost of C a p i t a l " , J o u r n a l of B u s i n e s s , October, 1955, pp. 511-516. Fu r t h e r development of ROI concept. S p i r o , A. " E m p i r i c a l Research and the Rate of I n t -e r e s t " , Review of Economics and S t a t i s t i c s . February, 1958, pp. 52-67. A d i s c u s s i o n of the i n f l u e n c e of i n t e r e s t r a t e s on long and s h o r t term investment funds. S t i l e s , K. " C a p i t a l E x p e n d i t u r e s , P e r p e t u a t i n g the Past or F o r e c a s t i n g the Future?", J o u r n a l of Accountancy, September, 1956, pp. 37-46. - 100 -A review of the pros and cons of the c r i t e r i a of n e c e s s i t y , payback, and r a t e of r e t u r n . W e l l s , A r t h u r , J r . "Economic A n a l y s i s f o r B e t t e r Investment D e o i s i o n s " , N.A.A. B u l l e t i n , October, 1958, pp. 429-427. A d i s c u s s i o n of the m e r i t s of the present worth approach to r e t u r n on investment measure-ment . APPENDIX A APPENDIX A An example i l l u s t r a t i n g the d i f f e r e n c e between net p r o f i t (income) and the i n t e r n a l sources of funds, (see Chapter I I I , The Supply of C a p i t a l ) . Dominion S t o r e s L i m i t e d 2 0 C o n s o l i d a t e d Statement of Income and Expenditure (condensed) Year ended Maroh 21, 1959. S a l e s Cost of Goods S o l d Expenses ( i n c l u d i n g d e p r e c i a t i o n ) Taxes on Income Net P r o f i t f o r the year $ 356,424,351 293,502,871 62,921,480 49,662.922 13,258,558 6,525.000 $ 6,733.558 20 Source: Dominion S t o r e s L i m i t e d , Annual Report, 1959. - 108 -In t e r n a l . Sources of Funds S a l e s #356,484,351 T o t a l cash charges a g a i n s t s a l e s : Cost of Goods S o l d $893,502,871 Expenses ( e x c l u d i n g d e p r e c i a t i o n ) 46,427,595 Taxes on Income- 6,170.000 346,100.456 Cash generated by o p e r a t i o n s 10,323,885 Sal e of f i x e d a s s e t s 8.811,893 T o t a l Funds from I n t e r n a l Sources $ 19,135,778 I t i s acknowledged that the same r e s u l t as above may be obtained by the con-v e n t i o n a l source and a p p l i c a t i o n of funds statement. The Dominion S t o r e s Annual Report 1959 p r e s e n t s the i n f o r m a t i o n t h i s way: Sources of Funds: Net P r o f i t $6,733,558 Book value of f i x e d a s s e t s s o l d 8,811,893 D e p r e c i a t i o n provided - not r e q u i r i n g cash o u t l a y 3,235,327 P r o v i s i o n f o r f u t u r e income taxes 355,000 ",135,778 However, i t i s i n a c c u r a t e to view d e p r e c i a t i o n as a source of funds which i t i s commonly s a i d to be. - 103 -In Chapter I I I (page 16) i t was s t a t e d "the amount a v a i l a b l e from t h i s ( i n t e r n a l ) source w i l l depend on th r e e f a c t o r s : the a b i l i t y of the business to generate cash, e x i s t i n g committments f o r the use of cash, ... and the d i v i d e n d p o l i c y " . T h i s may be i l l u s t r a t e d by a f u r t h e r example from the Dominion Store Annual Report, 1959: T o t a l Funds from I n t e r n a l Sources #19,135,778 (the a b i l i t y to generate cash) S i n k i n g fund i n s t a l l m e n t s 960,000 ( e x i s t i n g committments f o r the use of eash) 18,175,778 Div i d e n d s to sh a r e h o l d e r s E,012,501 ( d i v i d e n d p o l i c y ) Net Funds a v a i l a b l e from I n t e r n a l sources $16,163 ,"277 Use of Funds C a p i t a l expenditures Increase i n working c a p i t a l $13,048,5£1 3,114,756 $16,163,277 APPENDIX B APPENDIX B The E f f e c t of Taxation on the R.O.I. C a l c u l a t i o n C a l c u l a t i n g r e t u r n on investment as i l l u s t r a t e d i n Chapter V I I I on a "before tax" b a s i s a v o i d s some c o m p l e x i t i e s i n the c a l c u l a t i o n but may a l t e r the r e s u l t s s i g n i f i c a n t l y . Obviously a h i g h e r minimum r a t e of r e t u r n must be used than i f an " a f t e r tax" b a s i s i s adopted. By t a k i n g i n t o c o n s i d e r a t i o n the a f t e r tax e f f e c t ( c o n s i d e r -i n g taxes as a cash c o s t ; an outflow of cash) a s i g n i f i c a n t l y more accurate answer may be ob-t a i n e d . A formula f o r use under these c o n d i t i o n s i s developed b e l o w : 2 1 I r Investment d - r a t e of d e p r e c i a t i o n per year f o r tax purposes t - r a t e of t a x a t i o n n - number of y e a r s i - r a t e of i n t e r e s t on minimum r a t e of r e t u r n G - o p e r a t i n g c o s t s 21 G.G. Edge, op. c i t . , pp. 39-40. - 104 -De p r e c i a t i o n - year 1 year 2 year 3 year n Taxation c r e d i t year n I d I d (1-d) I d (l-d)2. I d (1-d)n-1 l t d ( l - d ) n - l Present worth of tax c r e d i t s ( d i m i n i s h i n g balance d e p r e c i a t i o n a p p l i e s to an i n f i n i t e number of y e a r s ) : ( r H ) + (H4) ( i + d) « l t d = l t d = I Present worth of investment ( a f t e r tax b a s i s ) : = I - r I ( A % ) - I Annual cost on an a f t e r tax b a s i s : * Annual cost X (l - t d ) V i + d / Tax e f f e c t on operating c o s t s : C ( 1 - t ) - 105 -Example 2(a) - (see page 49) tax r a t e assumed - 50% d e p r e c i a t i o n r a t e assumed - 6% S t e e l tank - Annual cost - #3,126 S t a i n l e s s s t e e l tank - Annual cost - $4,444 Annual c o s t s on a f t e r tax b a s i s : S t e e l tank: $3,126 x (1 - .50 x .06^ \ .17 + .06/ r 3,126 x .8696 = $2,718 Maintenance c o s t s : $1,600 ^ (1-.50) = 800 $3,518 S t a i n l e s s s t e e l tank - $4,444 x ( 1 - .50 x .06 ) \ .17 + .06/ t 4,444 x .8696 = $3,865 Maintenance c o s t s : $100* (1-.50) • 50 $3,915 Therefore choose the s t e e l tank. - 106 -Example 4(a) (see page 50) S t e e l tank - ( l a s t i n g 5 years) - annual cost $5,126 - a f t e r tax b a s i s $2,718 S t e e l tank - ( l a s t i n g 8 years) - annual cost - a f t e r tax b a s i s Maintenance - a f t e r tax b a s i s ^2,377 2,067 150 Eg.217 Therefore p a i n t the tank and r e p l a c e every e i g h t y e a r s . Example 8(a) (see page 53) Annual c o s t of machine — a f t e r tax b a s i s 3,126 2,718 Annual c o s t savings - a f t e r tax b a s i s $3,000 $1,500 The r e f o r e : $2,718 1,500 Add6d e a r n i n g s ($1,218) Cost savings are inadequate to j u s t i f y purchase of machine. - 107 -Example 14(a) (see page 61) D e p r e c i a t i o n r a t e 20% Tax r a t e 50% Net cost saving $30,000 - a f t e r tax b a s i s * G ( l - t ) 15,000 C a p i t a l Cost 100,000 - a f t e r tax b a s i s = $100,000 ( 1-..50 x .20 ) N .17 + .20 / = 100,000 (1- .27) = 100,000 x .73 = 73,000 Rat i o savings to c a p i t a l cost -15 t000 - 0.2065 73,000 C a p i t a l recovery f a c t o r : 10 years - 15% = .1993 10 years - 16% = .2069 R.O.I, ( a f t e r tax b a s i s ) : = 15 + / .2055 - .1993 \ \ .2069 - .1993 / = 15 + 62 76 = 15.82% - 108 -Example 18: The present worth o i the tax c r e d i t on the c a p i t a l cost i s determined by the pre-v i o u s l y described formula. Next the tax rate i s a p p l i e d to the p r o f i t before d e p r e c i a t i o n and the balance converted to i t s present worth. The r e s u l t i s corrected by the tax c r e d i t and the ROI c a l c u l a t e d . C a p i t a l Cost #100,000 Tax Rate 50% A d d i t i o n a l Working C a p i t a l #20,000 De p r e c i a t i o n Rate 10% ( d i m i n i s h i n g balance) Salvage Value N i l P r o f i t Before D e p r e c i a t i o n 50% Year Taxes Cash Flow 0 1 2 3 4 5 6 7 8 (#120,000) 10,000 20,000 30,000 50,000 40,000 40,000 30,000 10,000 20,000* 5,000 10,000 15,000 25,000 20,000 20,000 15,000 5,000 5,000 10,000 15,000 25,000 20,000 20,000 15,000 5,000 20,000 Working C a p i t a l ) Present worth of tax c r e d i t I (8%) (7%) = #27,780 #28,410 - 109 -1,000 8% 7< Year Gash Flow Present Worth Present Worth 0 (120) 1.0000 (120) 1.0000 (120) 1 5- .9259 4.6 .9346 4.7 2 10 .8573 8.6 .8734 8.7 3 15 .7938 10.9 .8163 12.3 4 25 .7350 18.4 .7629 19.1 5 20 .6806 13.6 .7130 14.3 6 20 .6302 12.6 .6663 13.3 7 • 15 .5835 8.8 .6227 9.3 8 25 .5402 13.5 .5820 14.6 C a p i t a l Cost Q?ax Credit27.8 28.4 (1.2) 5.7 Return on Investment = 7 + (5.7 •+• 1.2 \ 5.7 - 7.12% 

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