THE EFFECTS or FEDERAL- lNCOME TAXES on V CAPITAL BUDGETING ~ Thesis for ‘thé Degree of Ph. D._ MICHIGAN STATE‘UMVERSITY - , James- Wyatf‘ Edwards 1966 7 NM‘u-‘z‘ax Zo.‘ ‘ , ,_‘ “3 ---- J CE‘FWE-Jflwli'v'i-tmga-ruq... w- MWmmmmn man 93 00647 7313 ! Michigan Sun: University This is to certify that the thesis entitled rm; EFFECTS UF FEOhlleL IkCUI‘uE TAXES UN CAPITAL BUJGETIAG presented by James Wyatt Edwards has been accepted towards fulfillment of the requirements for Ph ,0 degree mm Administration /’ : Major lessor Date Hg}! 11. 1966 0-169 DC} 361539: \ ’ rat‘- I Ch A é 7 «r 1 THE EFFECTS OF FEDERAL INCOME TAXES ON CAPITAL BUDGETING BY James wyatt Edwards AN ABSTRACT OF A THESIS Submitted to Michigan State University in partial fulfillment of the requirements for the degree of DOCTOR OF PHILOSOPHY Department of Accounting and Financial Administration 1966 ABSTRACT THE EFFECTS OF FEDERAL INCOME TAXES ON CAPITAL BUDGETING By James wyatt Edwards The problem examined in this thesis involves the influences of Federal tax provisions on capital budgeting programs of business firms. Substantial financial literature is available in which the theoretical influences of taxes are discussed. Studies have been made examining the effects on investment decisions of income taxation in general, while others have considered only one or a few selected provisions. The primary objectives of this study are (l) to draw together some of the scattered theoretical aspects of capital budgeting specifically related to income taxes; (2) to examine the practices followed by firms in considering tax provisions in project evaluations; (3) to point out under- lying patterns of practices and their consistency with theory and the reasons given to justify such practices, and (h) to provide information that may promote better decision making and efficient use of funds by firms and serve as a guide to future tax policy. Information was gathered by interviews with top financial and tax officials in forty-four United States corporations, and by reviews of many of the capital budgeting manuals and forms being utilized. A broad cross-section of industries is represented by the firms visited, and their total capital expenditures during 1965 was approximately $19.5 billion. The entire investment decision-making process was examined to provide a frame of reference for tax consider- ations, and the principal finding was that there has been a definite gradual shift toward the use of time-adjusting acceptance criteria for proposal evaluations. Three-fourths of the firms were using discounting techniques for all or some proposal evaluations. The following general conclusions about the incentive effects of the investment credit, the depreciation guideline system, and the corporate tax cut are discussed in the thesis. (1) The vast majority of the executives stated that only nominal incentive effects have occurred on individual investment proposals. (2) The supply of funds effects were generally described as moderate in most firms. These effects suggest at least a partial corroboration of the unshifting results for tax rate reductions discussed by Krzyzaniak and Musgrave. (3) The size and rates of increase in new capital outlays by the firms in recent years imply that the actual incentive effects may have been somewhat stronger than was acknowledged in the interviews. Several factors have resulted in the lack of recognition of the possible incentive influences of the tax measures. First, despite widely heralded improvements in the "business investment climate," substantial uncertainties exist in the minds of the interviewees concerning future tax policy changes. Second, the speed up in tax payments for corporations has dampened enthusiasm about the measures. Third, many firms were in strong or excess liquidity positions when the measures began to take effect. Fourth, the provisions have been selective in nature and implemented gradually. Fifth, the crude evaluation techniques utilized in some firms has precluded a recognition of the incentive value of the measures. Finally, some firms were just beginning to be forced into greater reliance on external funds at the time of the interviews. Tax policy recommendations were made suggesting that hasty fiscal policy changes should be avoided until the restrictive monetary and fiscal actions already implemented have had time to become operative and dampen the inflationary tendencies in the economy, and that some of the measures be liberalized in the long run to more firmly entrench their incentive value in the business community. Two chapters in the thesis include a discussion of tax considerations involved in such factors as working capital flows, salvage values, operating and capital losses, effective tax rates, and inflation and other forms of risk. A variety of reasons was given by the numerous firms that do not consider some of these factors, many of which appeared tenuous at best. THE EFFECTS OF FEDERAL INCOME TAXES ON CAPITAL BUDGETING BY James wyatt Edwards A THESIS Submitted to Michigan State University in partial fulfillment of the requirements for the degree of DOCTOR OF PHILOSOPHY Department of Accounting and Financial Administration 1966 Copyright by JAMES WYATT EDWARDS 1967 ACKNOWLEDGMENTS Many obligations have been incurred in the prepara- tion of this work. I wish to acknowledge my gratitude to Professor Charles J. Gaa who supervised the study and made many valuable suggestions to improve the technical aspects and clarity of style. At all stages I had the help and encouragement of the other members of my thesis committee: Professor Herbert E. Miller and Professor Paul E. Smith. I am especially grateful to Professor James Don Edwards, Chairman of the Department of Accounting and Financial Administration, for providing an atmosphere particularly conducive to progress in the doctoral program and for marshalling the substantial resources necessary for completion of it. I am particularly indebted to the National Association of Accountants for the grant-in-aid to promote the original research for the thesis, and to Profes- sor William A. Paton and the H. B. Earhart Foundation for the fellowship provided during this time without which the research project could not have been undertaken. I owe an important debt to my Mother and Father who guided and counseled me through the many earlier collegiate Years that were necessary for the undertaking of the doctoral program. Finally, I owe an eternal debt to Randal and Jamye, and most of all to my wife, Imogene, without whom none of this work could possibly have been completed. ii TABLE OF CONTENTS LIST OF TABLES . . . . . . . LIST OF FIGURES . . . . . . Chapter I. INTRODUCTION . . . . II. MATHEMATICAL ACCEPTANCE CRITERIA III. IV. INITIAL INVESTMENT AND CASH FLOW PROJECTIONS . . . v. BROADER ISSUES: RISK, AND INFLATION VI. CONCLUSIONS AND TAX POLICY CONSIDERATIONS APPENDIX A O O O O O O O O 0 APPENDIX B O O O O O O O O O BIBLIOGRAPHY O O O O O O O 0 iii EFFECTIVE TAX RATES, FEDERAL INCOME TAX INCENTIVE PROVISIONS Page iv 56 116 155 191 201 208 P32 Table 1-10 2-10 LIST OF TABLES 196% Operating and Financial Data of H Firms . . . . . . . . . . . . . . Utilization of Mathematical Acceptance Criteria by RA Firms Interviewed . . . Approaches to Considering Investment Credit in Project Evaluations . . . . Importance of Depreciation Guideline Provisions . . . . . . . . . . . . . . Utilization of Accelerated Depreciation Methods for Federal Income Tax Purposes Salvage and Terminal Factors Considered in Proposal Evaluations . . Working Capital Factors Considered in Proposal Evaluations . . . . . . . . Factors Evaluated as Capital Expenditures Effective Tax Rate Factors in Proposal Evaluations . . . . . . . . . Approaches to Considering Risk in Proposal Evaluations . . . . . . . . . iv Page 10 77 86 108 128 138 1N1 162 181 Figure 2-10 3-10 LIST OF FIGURES Illustration of Rates of Return . MAPI-CTA Study of Tax Incentives Page CHAPTER I INTRODUCTION The management of invested capital is the universal tnasiness problem. It thus encompasses decisions involving naarket strategy, new product lines, public and labor :relations, and research endeavors. These decisions are iiitegral, but subsidiary, issues of management's adminis- ‘tration of capital. A fairly well defined theoretical capital budgeting :framework exists in the literature of the academician and researcher. During the last quarter of a century, and particularly within the last decade, the tools of analysis long discussed in academic realms have been applied to the capital budgeting problems of business organizations with an increasing degree of theoretical sophistication. Capital budgeting is viewed in a broad connotation in this study. It may be defined as the process of fore- casting, approving, and monitoring outlays for capital Projects. The capital budgeting process exists in all firms. In many organizations the formality and explicitness of the Process is of recent venue. This increased emphasis on the Planning and control of capital expenditures is closely interrelated with much of the Federal income tax legislation enacted in recent years. Some of the major legislation aimed at stimulation of investment includes the accelerated depreciation provisions in the 195% Code, the depreciation guidelines enacted in 1962 and amended in 196%, the invest- ment credit provisions of 1962 and 196%, and the corporate tax rate reductions effected during 196% and 1965. The broad problem examined in this thesis involves the effects of'such Federal income tax provisions on capital budgeting decisions. ijectives of the Study The primary objectives of this study are: (l) to draw together the theoretical aspects of capital budgeting that are specifically related to income tax effects; (2) carefully to analyze individual firms and examine the objectives of particular practices regarding income tax considerations in capital investment analyses; (3) to point out underlying patterns of practices which exist, and consistencies or inconsis- tencies with their objectives and the theoretical aspects of capital budgeting; (H) to derive conclusions which may g. assist other firms in choosing methods that may be used with reliance to attain similar objectives, 2. promote more efficient use of funds by firms and resource allocation in the national economy, and c. serve as a possible guide to public policy in the formulation of future tax programs. This study should at least partially fill an exist- ing void in the literature. A substantial amount of theorizing, Congressional testimony, and business literature has been devoted to the expected impact of major tax legis- lation on corporate investment decisions and resource allocation in the national economy. Several attempts have been made to examine actual effects of some of these legis- lative provisions. Others have attempted to.ascertain ‘whether or not firms have considered taxation effects in a general way in the capital-expenditure decision-making process.1 Most of these efforts have been splintered in approach, and no attempt has been made to determine the extent to whichmall major tax considerations have been formally incorporated in the various stages of the capital budgeting process of business enterprises. A further problem is that no previous attempts have been made to relate many of the practices followed in con- sidering income taxes in the capital budgeting process to the reasons used to justify these practices. Adequate reasons sometimes exist for ignoring certain theoretical aspects of capital budgeting and detailed tax considerations. These reasons and the related practices should constantly be.sut- jected to scrutiny for inconsistencies and outright errors in the investment decision-making process. 1For example, see the excellent study of Donald F. Istvan, Capital-Expenditure Decisions: How They Are Made in Lar e Cor orations,FIndiana Business Report No. 33 lBloomington, Indiana: Bureau of Business Research, Graduate School of Business, Indiana University, 1961). Approach of the Study Information for the study has been gathered primarily by personal interviews with top financial and tax officials in forty-four United States corporations, and by reviews of capital budgeting manuals and forms used by many of the 2 .firms. A broad cross-section of industries is represented ‘by the firms visited. These industries are listed below. Airlines Automotive Building materials Capital goods Chemicals Communications Defense Electrical equipment Metals Office machinery Paper and packaging Pharmaceutical Rails Rubber Steel Utilities Others Several criteria were utilized in the selection of :firms included in the study. Expenditures for plant and equipment by the firms were approximately $11.0 billion in 2196H and $12.5 billion in 1965. This amount represents atmut one-feurth.of the total capital outlays made by U. S. <3orporations during 1965. Seventeen of the firms are the largest in total asset size in their respective industries. 2The field interviews were held primarily during the summer months of 1965. Subsequent correspondence with some of the executives interviewed has served to corroborate certain information. Three-fourths of the companies are among the top five in asset size in their industries. Total sales, assets, and net after-tax profits amounted to $115.3, $119.2, and $8.8 billions respectively in 196% (Table 1-1). The average number of persons employed by these firms during 196% was approximately H.3 million (Table 1—1). Other criteria utilized in the selection of firms were such tax :factors as substantial investment credit carryforwards, Operating losses, realization of capital gains or losses, andtflmafiling of consolidated tax returns. TABLE 1-1 1964 OPERATING AND FINANCIAL DATA OF RH FIRMS Net Profit Average Total after Number of Salesa Assetsa Taxesa Employees Industrial Firms S 89.5 S 71.1 E 6.h 3,1H1,000 .Fortune‘s "Top 500" $266.5 $22h.7 $17.2 lO,h6h,OOO Percentage Relationship 33.6% 31.6% 37.2% 30.0% Summary of RH Firms Industrial firms E 89.5 E 71.1 E 6.% 3,1h1,000 Regulated and other firms 25.8 #8.1 2.h 1,113,000 Totals $115.3 $119.2 E 8.8 h,25h,000 ¥ Sources: Fortune, LXXII (July, 1965), lh9—168; Annual published financial reports of firms. aFigures are in billions of dollars. Order of Presentation There are five additional chapters in this thesis. The objectives listed on page 2 have been followed in each chapter. An effort has been made to stipulate the basic 'theoretical issues involved, with particular emphasis being placed on tax considerations. This effort is followed in (each instance by an attempt to outline the patterns of jpractices observed and to relate them to the reasons given for such practices. Consistencies and inconsistencies between theory, objectives, and practices are set forth and analyzed. Chapter II includes an examination of various accept- ance criteria utilized by the companies visited. This information serves importantly as a frame of reference for subsequent chapters. Chapter III considers several so-called tax incentive Iarovisions that are included in the Internal Revenue Code. (Shapter IV is a discussion of the tax effects involved in a jprOper determination of the investment outlays necessary for a.proposal and the benefits that are expected to result from such outlays. Chapter V is an examination of certain broader tax aspects of capital budgeting. Several tax factors that are not always related to specific proposals are examined. The elements of risk and uncertainty in the capital budgeting process are also discussed in Chapter V. An attempt is made to indicate that all of the previous refinements involving income tax factors and the use of mathematical acceptance criteria may be for naught if the element of risk is not given explicit recognition in the'decision-making process. Chapter VI presents a brief summary and a statement of tax policy and other conclusions. CHAPTER II hATHELATICAL ACCEPTANCE CRITERIA There are two clearly discernible stages in the capital-expenditure decision-making process. The initial stage involves a determination of the necessary investment in a project and the benefits which are expected to result. The second stage concerns the application of mathematical acceptance criteria to the results obtained in the first stage. Income tax considerations permeate both stages of the decision-making process. The typical chronological order of the discussion of these two stages is reversed in this study. The basic theoretical issues and the practices of firms in the use of mathematical acceptance criteria are examined first. This sequence facilitates a more meaningful discussion of the income tax factors that are examined in Chapters III-V. The influences of many of these tax factors on the important acceptance criteria in use are included at various points in these chapters. A basic mathematical framework is presented in equation form in Appendix A. host of the mathenatical acceptance criteria discussed in this chapter are based on these equations. The framework is modified and expanded as the need arises at various points in later chapters. 8 \O No attempt will be made to examine all of the contro- versial theoretical issues involved in the use of various mathematical acceptance criteria. This is not the primary purpose of this thesis. These issues will be examined only if they can arise as a result of income tax considerations.1 The controversy raging over the correct derivation of a firm's cost of capital for use in capital budgeting decisions is Skirted entirely in the initial discussion in this chapter. It is assumed that a properly determined cost of capital is available for use. The cost of capital con- cept is discussed briefly in the theory section on the recovery period criterion in this chapter. The concept is taken up again in Chapters III and V. Table 2-1 presents a tabulation of the number of firms in the study that are utilizing various mathematical accept- ance criteria as their primary measures of the economic worth of capital projects. The number of firms using the criteria for supplementary purposes or for particularly important or special projects is also presented in Table 2-1. The executives of some companies could not, or would not, indicate that a single criterion was more important for decision-making purposes than one or more others. This reluctance on the part of such executives results in more than one criterion being listed as primary for certain firms . For a general discussion of the time and size disparity problems in investment decisions see J. Lorie and L. J. Savage, "Three Problems in Capital Rationing," Journal of Business, XXVIII (October, 1955), 229-39. IO and the totals not amounting to the number of companies visited. TABLE 2-1 UTILIZATION OF MATHEMATICAL ACCEPTANCE CRITERIA BY MR FIRMS INTERVIEWED ‘- — r _— Criterion Used as Used as a Used for a Supplement Major or Primary to Primary Special Criteria Totals Criterion Criteria Proposalsa TIME-ADJUSTING 3} l2 ,3 ll Net Present Wbrth 2 l 1 Internal Yield 26 13 2 11 Uniform Annual Charge 5 5 MAPI l .1. RATES OF RETURN 21 lg § RECOVERY PERIOD 3& .l2 IE I PERCENTAGE OF SALES g, I! '5 OTHER MEASURES 'l l k aMajor proposals involve large dollar outlays or projects of particular importance to firms. Special proposals involve leasing arrangements and other projects which are viewed as warranting an evaluation by other than the primary criteria used for smaller conventional proposals. The criteria are discussed in the rest of this chapter in the following format: net present worth (PW), internal yield (IY), uniform annual charge (UAC), the Machinery and 11 Allied Products Institute formula (MAPI), so-called account- ing or book rates of return (ROR), recovery period (RP), return on sales (ROS), and others. The letters in paren- theses in the previous sentence are utilized in subsequent discussion to facilitate brevity. The theoretical precepts of each of the measures is discussed first. This discussion is followed by an examination of the practices found regard— ing each measure and the reasons given by the executives interviewed for such practices. The first three criteria listed are the time-adjusting approaches generally used for project evaluations. They are general theoretically correct methods available to determine the desirability of investment alternatives over their expected economic lives.2 The net present worth and internal yield measures are first discussed briefly from a theoretical vieWpoint. Since their use is usually so closely allied, the practices of the firms that utilize these two measures are discussed together. The theory and practices regarding the uniform annual charge approach are discussed following the net present worth and internal yield sections. Net Present werth--Theory The formulation for the present worth concept is set forth in the mathematical framework in Appendix A. To illus- 2The MAPI formula that is discussed in a later section of this chapter is a theoretically sound approach to evalua- tions for replacement-type proposals and does involve some discounting elements. Also, the total wealth concept that is presented in Chapter III is a generally correct measure of economic desirability. 12 trate the net present worth approach, consider the follow- ing hypothetical situation. Illustration II—l Assume a project requires an initial investment of $20,000 at time zero, that annual net cash benefits of $2,981 are expected for ten years, and that the cost of capital is expected to be 7%. The time scale below shows the cash flow pattern hypothesized. (20,000) 2,981 2,981 2,981 2,981 . . . . .2,981 2 x I z x, x t t t O O 0 O O t 0 t1 t2 3 u 10 The present worth of the expected cash inflows for the period to through th amounts to $20,937. Calculations {for Illustration 11-1 and other illustrations in subsequent <2hapters are shown in Appendix B. The net present worth of tzhe proposal is $937 ($20,937 - $20,000). This amount can IJe interpreted as follows. If $20,937 is borrowed at the Expecified cost of capital rate of 7% and the $937 is paid iJnmediately to the firm's shareholders, exactly enough funds Mnill remain available to liquidate the debt and the financing kaarges over the life of the project. Since the present hflDrth of the expected net cash benefits exceeds the initial irnvestment outlay, the internal yield on the project must be glweater than the company's cost of capital rate. This fact 153 discussed in the next section. 13 Internal Yield-~Theory Another theoretically sound approach to project evaluations is variously called the Profitability Index, Interest Rate of Return, Discounted Cash Flow Return, IInvestors Method, and the Internal Yield. The latter term is used in.this study. The internal yield (IY) on a pr0posal is generally ciefined as the discount rate which equates all cash inflows and outflows to a zero sum at the present date. The typical arpproach to determining the IY is to use the same discount- 111g procedure utilized previously in the NPW derivation. Theo or more trial and error discount rates are required in nuast instances. It was noted in the preceding section that tile IY on the proposal being considered must be higher than 7Uz since the NPW exceeds zero. When a 9% discount rate is lused.a negative NPW of -$869 is obtained. This result inuolies that 9% discount rate must be higher than the true Yi£3ld on the proposal. The yield can be approximated by interpolating linearly between the results which were Obtained for the 7% and 9% rates. The true yield on this PTTIposal is exactly 8%, as is shown in the calculations Presented in Appendix B for Illustration 11-1. The internal yield represents the maximum rate a firm c311 pay for the use of its funds and not lose on a project. Th143 rate is usually interpreted as the return on each unit of <3apital outstanding for each period of a project's life. 14 Each cash inflow is thus viewed as representing a return on the capital outstanding for the period, and the remainder as a return of the capital invested. Net Present North and Internal Yield--Practice Table 2-l indicates that a total of thirty-three of the firms interviewed are using time-adjusting procedures either as a primary criterion or for certain types of decisions. Five of the nineteen companies using these methods as the primary analytical tool follow the UAC approach that is discussed in the next section. Only one firm utilizes NIH as the primary criterion and this is in conjunction with IY as a supplementary guide. One other firm uses KPH as a supplement to the IY in the decision- naking process. Table 2-l shows that twenty-six companies are using the IY approach and half of them use it as their Jurimary evaluation criterion. The other thirteen firms use IIY as the primary criterion for special or major projects (Inly, or as a supplement to other techniques. The fact that a method is used as the primary (iriterion in a firm does not necessarily imply it is used CHI all investment projects. host companies make some decisions on the basis of competitiveness, need, and post- IMIneability. Only a few of the companies interviewed use tile discounting procedures for all proposals processed through the capital budgeting framework. Several others iruiicated these techniques are used for all but a few rela- 15 tively small dollar-sized proposals. host of the remain- ing companies use NPW or IY primarily in the evaluation of large major expansion or research type proposals. Several of these firms are phasing out the use of other currently accepted non-discounting evaluation criteria. The preceding remarks indicate that a gradual, but distinct, shift is occurring toward the use of relatively sophisticated capital budgeting techniques in many of the firms interviewed. One of the primary benefits of a state- ment of findings in a study such as this is the delineation of the practices followed in the use of certain analytical techniques, under given conditions, at a particular point in time, and with definite objectives in mind. It is then possible for others to evaluate and examine the findings .and determine whether such approaches or modifications ‘thereof might be useful for their decision-maxing purposes. All of the factors that are weighed by all of the Ifirms in their individual decision-making processes could 11cm possibly be determined or catalogued. The rest of this iseaction is an effort to consider the most important general ifkactors that influence many of the firms in their capital ENJdgeting analyses. These factors provide important back- gfiflound information for specific tax effects discussed later, arui are based on the comments offered by the company execu- tlives, examination of capital budgeting manuals and forms, INIblished financial reports, and general external conditions. 16 Nature of Industry and Competition Approximately one-third of the companies that were visited indicated that the highly competitive nature of their respective industries dictates many investment decisions. The executives interviewed in these firms generally feel that the cost and effort involved in the use of the discounting techniques are not warranted for these kinds of investment decisions. Other companies interviewed in the study, often representing the same industry, gave this fierceness of competition as the main reason for the Ilse of discounting techniques. This latter group of firms feel that competition " makes it imperative that decisions be made with the best and most sensitive criteria available regardless of the pre—disposition toward certain proposals before the evaluation process is begun." Competitive pressures often dictate the general direction or broad investment Programs a firm must move toward. These pressures do not dictate nearly so frequently the choice of one of several alternative ways of achieving a pre-determined goal. It is in the choices between alternatives that many income tax Provisions become most important and that time-adjusting acceptance criteria are most useful. This distinction between bI‘Oad investment programs and the alternative ways of achiev- ing them must not be clouded by arguments about competitive Pressures on the former and not on the letter. In all but one of the industries represented in the study at least one firm was visited that uses a time- 1? adjusting technique for at least the major investment decisions that are made. Only two companies were inter- viewed in this particular industry. These companies may not be representative of the problems involved in capital- expenditure analyses in their industry. Complexity of Data Estimates Several of the executives that were interviewed said, "there is no justification in glorifying figures by the use (sf new-fangled techniques, and especially when tax complexi- ‘ties are involved." A statement was usually made to the Gaffect that it is more desirable to use rough approximations (Jf economic worth and concentrate efforts on the risks inherent in estimating the cash flows relating to a proposal chan to glorify the figures with the discounting measures. These statements are based on a mis-interpretation of what 113 accomplished by the use of time-adjusting techniques in timeir most basic form. These techniques do not generally adjust for risks related to the possible variabilities of tax effects or other cash flow estimates for investment PINDposals. Estimates for distant years are often subject to large errors in variability and are discounted more than early year estimates by the NPW and IY methods, but the diseounting is due entirely to the time value of money. The errors in variability in distant years are due to chang- ing tax laws, problems in forecasting sales volumes, pricing Patterns, wage pressures, market shares, and a multitude of 18 other factors. These errors can be considered in RIM and IY analyses through the use of special techniques discussed in Chapter V. These techniques are not a part of NEW and IY in their most basic form. It is these basic forms that are being rejected by firms in favor of more crude evalua- tion criteria. If the firms that have rejected the discounting techniques are in fact vigorously concentrating on the individual cash flow estimates, the most difficult part of the decision-making process is being accomplished. A judicious application of NPW or IY could strengthen the evaluation procedures in these firms without glorifying their carefully derived estimates at all. _§haracteristics of Investment Proposals Different types of investment proposals often involve (iifferent specific income tax provisions. For example, re- }Jlacement projects have certain characteristics that require (:areful evaluations in the estimation of tax effects on the IJenefits expected and on necessary investment outlays. ESome of these characteristics are discussed later in this (lhapter in the section on the EAPI formula, and in the next ‘tlrree chapters involving Specific income tax factors. The Elir‘gument was raised in some firms that the net present lNorth and internal yield measures are not readily adaptable tC) some of the tax complexities involved in making replace- Tmern;type decisions. These arguments cannot be refuted 19 without a complete review of each firm's entire capital budgeting program and all of their individual complexities. Executives in other firms nevertheless offered the opposite contention. The latter group of executives feel that in their firms the time-adjusting techniques are being used effectively regardless of the nature of the investment decisions and tax factors involved. Financial Position Many of the executives in companies that are not ‘utilizing the time-adjusting criteria indicated that an important factor in the reluctance to do so was that their companies were not in dire financial straits at the time of the interviews. They further indicated that the analytical tools currently in use would be adequate until their high :profitability and liquidity positions change substantially. £3everal comments about such reasoning should be made. First, Shame of the companies interviewed were in dire financial Ciifficulties. These companies used their poor financial rwssitions as a reason for not using the time-adjusting (triteria. Apparently every proposal accepted would result 111 such high savings because of gross inefficiencies in the IMist that it was felt there was little need to make use of irimgorous financial evaluations. The possible circularity ifl these arguments should be apparent. Conceivably a firm CCNJld use a highly liquid cash position as an excuse for ”not needing to" adopt new tools of analysis, and subse- 20 quently revert to an extreme capital rationing position and again ”not need to” make sophisticated analyses for capital investment proposals. The need for appropriately determining the profitability of capital projects does not change with the economic or financial position of a firm. Additional profits may be foregone through lax evaluations irrespective of a firm's current position. Second, the financial positions of the companies using the discounting techniques for investment decisions fell along the entire spectrum of extreme liquidity through capital rationing. This fact appears partially to corroborate the preceding point. Finally, it would seem a particularly desirable use of part of the excess funds held by some firms would be an implementation of a more sophisticated analytical process to spend other excess funds in future periods. Educational Issues Another important reason given for not using the time-adjusting tools of analysis was educational in nature. Iiany of the individuals involved in the investment decision- Itaking process claim these criteria are difficult to calcu- liate and implement. These same individuals often stated tfipat most tax factors are too difficult to consider in PIwoject analyses. These are not comments to be taken ILightly since most of the firms utilizing time-adjusting t€M3hniques indicated it was a slow, evolutionary, and often Extinful process to change from the use of other types of 21 analySes. Only a few companies did not encounter these difficulties when such tools were first implemented. The executives of these firms stipulated that when a formal capital budgeting program was initiated it was felt that the educational process might as well be relatively complete to begin with. These firms started their formal programs with the use of time-adjusting techniques calculated on an after-tax basis. This approach is the opposite of the one taken by some of the companies visited. Some of these latter firms have started their formal programs by using only crude before-tax measures and expect to utilize more sophisticated approaches in a few years. The danger in this viewpoint is the possibility that the cruder tools will become entrenched, and make the introduction of discounting procedures more painful or difficult to implement than if they were introduced at the outset.' .Personnel Orientation g This problem is related to the discussion in the lpreceding section. The personnel involved in the computa- tlional and judgmental phases of capital investment decisions ‘Laries quite widely, and depends on the nature of the firm, tflie administrative organization, management philosophy, and nkiny other considerations. Personnel with engineering and Iwacent academic business backgrounds are often involved in tflle initial computational and screening phases of decisions 22 to accept or reject proposals. many of these quantita- tively oriented people seem fairly well inclined toward acceptance or use of prOperly introduced analytical techniques. Although practices vary widely between com- panies, personnel such as supervisors, plant managers, and middle and upper management are often less inclined toward accepting the use of new mathematical criteria. Lack of time is one of the most important factors that influences the reluctance of some industrial personnel to scrutinize new evaluation methods. Tremendous demands on the time of these people stem from a variety of sources, and result in a natural tendency to push new ideas off to the periphery when business conditions are good. However, much of the time problem in calculating the IY and NEW measures has been substantially eliminated by short-cut techniques and through the use of computers. Many of the firms employing the time-adjusting methods indicated that computer programs are being utilized and are designed to ;produce after-tax yields under varying circumstances. .Although the use of computers often seems to be pointed to £18 a panacea for every problem faced by business firms, 'there is no denial that many of the firms visited have Iltilized them to substantially enhance the effectiveness of <2ertain phases of the capital-expenditure decision-making Iprocess. Irrespective of the wideSpread use of computers, 61 number of firms indicated that the computational time was 'Well spent even if conventional trial-and-error calculations 23 are necessary for determining internal yields. The argument that it is too costly and difficult for most personnel to make after-tax present worth and yield calcu- lations for capital projects has little substance. lfliS fact is particularly true if viewed in terms of the sub- stantial costs and efforts expended to correctly determine estimated benefits and investment outlays for new projects. The incremental costs necessary to subject these carefully derived estimates to time-adjusting techniques may be the most profitable outlays a firm can make. Future Plans Several of the executives interviewed indicated they were currently considering a switch to the use of the IY method. They expect to evaluate only major proposals on this basis initially. The method will then be gradually extended to other types of proposals. This kind of approach is quite workable. As more personnel become involved with the use of a new technique, the barriers to resistance and prejudices for other criteria can be gradually dissipated. {The possibility of employee consciousness of important basic :income tax factors can be greatly enhanced under such cir- cumstances . Some of the reasons for the utilization of NEW and TY ifiere offered in the preceding pages as rebuttals to some of 'the comments generally given by firms which are not using 'these methods. The principal reasons mentioned in the firms 2h visited for the use of these evaluation measures are summarized below. (1) They represent theoretically correct measures of the economic worth of capital projects. (2) Each method emphasizes the time dimension in evaluations and is sensitive to irregular cash flow patterns. (3) They are understandable and relatively easy to apply despite statements to the contrary. (4) The cost of capital is a relevant and important part of both approaches. (5) Both measures can be utilized effectively regardless of the nature of the proposal being evaluated. (6) The measures are especially sensitive to income tax provisions that may influence investment decisions. The relative merits of these two measures have been discussed prolifically in the literature. Some special assumptions are required for both measures to evaluate properly certain types of capital budgeting proposals.3 Some of these problems will be noted in the discussion of Specific tax factors in Chapters III-V. Uniform Annual Charge--Theory A third theoretically sound acceptance criterion is E1 method which determines an equivalent uniform annual 3See the comprehensive work of A. J. Lerrett and 1*. Sykes, The Finance and Analysis of Capital Projects (New York: John wiley a Sons, Inc., 19635, especially Ch. v; and.H; Bierman and S. Smidt, The Capital Budgeting Decision (New York: The I-Lacmillan 00., 1960), especially Ch. III. 25 charge for all outlays related to a capital project. This approach is variously called uniform annual charge, annual capital charge, annual level premium, annual revenue requirement, sinking fund return, and others depending on how it is computed. The method is widely discussed in the literature of engineering economics.1+ The two variants found in the field interviews are discussed briefly below. They are called the capital recovery charge and the sinking fund return variants. The ideas are not at all new when closely examined, and it is strange that they have not received more attention in the literature of financial management. The theory behind the uniform annual charge (UAC) Inethod is as follows. Over the life of an asset several 'types of costs must be recouped including the initial invest- IneINQ expected annual Operating costs, and a charge for the minimum return which can be earned from an alternative ixrvestment. These costs frequently are incurred in an ixnregular pattern over a project's economic life. The UAC Hmrthod attempts to simplify some of the time-adjusting cal- (Hilations involved in the evaluations of capital—expenditure PITIposals. The measure results in a determination of the eqxtivalent uniform annual net cash benefit which will 1+See George A. Taylor, Managerial and Engineering My (Princeton, New Jersey: D. Van Nostrand Company, 1K3o, 96%). This author argues vigorously throughout his text timt UAC is worthy of consideration as the major criterionfor evaluation of alternative investment prOposals. 26 recover the amount invested plus a minimum required return over an asset's expected life. Capital Recovery Variant The capital recovery variant involves the use of equations developed in Appendix A. Illustration II-l shown on page 12 for the NPW criterion is continued in the following discussion. The illustration assumed an initial investment of $20,000, expected net cash benefits of $2,981 for ten years, and a cost of capital of 75. The UAC for such a project amounts to $2,8H8. This figure is derived in Appendix B and should be interpreted as follows. Uniform annual net cash receipts of $2,848 are necessary to recover exactly the initial outlay of $20,000 if the firm's cost of capital is 7% as hypothesized. Each of the receipts of $2,8h8 would represent a 7% return on the capital outstanding each year and the balance would be con- sidered a return of capital. Since the net receipts expected from the proposal amount to $2,981 annually the ‘UAC criterion would indicate that acceptance of the project .is justifiable. The same decision was reached using the IJPW and IY criteria. This variant of UAC does not depend on the actual czapital recovery pattern being uniform. It merely results Sin.the determination of an "equivalent” uniform annual (Hash flow series which can be mathematically equal to any eXpected flow patterns that would result in the recovery 27 of the capital invested and the minimum rate of return over the period specified. The method is essentially an annualizing process which can restate an irregular cash flow series into a mathematically equivalent uniform present worth series for convenience in the analysis of capital projects. SinkinggFund Return Variant The sinking fund variant of the UAC criterion is based on the so-called annuity method of depreciation. Deprecia- tion of an asset is calculated by this method by determining the series of equal annual payments or deposits which are necessary to repay the principal amount plus interest over the expected life span of the project. Since the deposits are viewed as being made into a sinking fund with none of the investment being recovered until the termination of the asset's life, interest must be paid each year on the total initial outlay. The formulation of the concept of a sinking fund in Appendix A is used in Appendix B to derive the same ‘uniform annual charge of $2,8k8 since the variants are only ealternative interpretations of what the amount should repre- sent. According to the capital recovery variant part of f the variants. Illustration lI-2 Figure 2—l presents data for two proposals currently being considered by a firm. Proposal G requires a current investment outlay of $220,000 and has an expected life of ten years. This proposal has estimated net cash benefits after taxes (NCBAT) of $10,000 in year 1. These benefits are expected to increase by $10,000 annually through year 10. Proposal H requires the same outlay and has the same expected economic life as Proposal G. The HCBAT predicted for year 1 amounts to 973,000. These benefits are eXpected to diminish by $8,000 annually through year 10. ll 50} income tax rate is expected, and both proposals . Inive zero salvage estimates at the end of year 10. It 36 is further assuned for the sake of simplification that losses on individual projects cannot be offset against gains on other projects and that loss carryback and carryover provisions are not available. These factors are discussed in Chapter V. The internal yields approximated in Appendix B are 153 and 16.8% for Proposals G and H reapectively. If funds are assumed to be limited and the proposals are conflicting and independent, the IY pproach would dictate the acceptance of II as the more desirable investment. A comparison of this :result with the decision based on the three ROB variants will ggive some indication of their possible usefulness and correct- 11883 as measures of profitability. IEnitial Investment Variant Proposal G has a total book profit of $330,000 over fists economic life and Iroposal H has a total profit of $2150,000 (Figure 2-1). Based on the annual average profits of $33,000 and $15,000 and the identical amount of initial iIIvestment of $220,000, Proposal G has the higher rate of Iwaturn. The rates are 153 and 6.75 for G and K respectively. Truis method would result in a choice of Proposal G which is time opposite of the result given by the IY approach. The fundamental fallacies in this ROR variant are the failure to consider the timing of expected benefits, and a mis-interpretation of what the annual cash inflows represent. Figure 2-l. Illustration of Rates of Return (1) (2) (3) (a) (5) Book Depre- After Tax 4 + 1 Year Value ciation HCBAT Income Yearly 303 F .L01: C' 532": 0 8220,000. q _- w -_ g -- __' 1 198,000. 822,000. 810,000. 8(12,000.) (5.5g) 2 176,000. 22,000. 20 ,000. ( 2,000.) (1.04) 3 15A, 000. 22,000. 30, 000. 8,000. 4.5% h 132,000. 22,000. 40 ,000. 18,000. 11.7” 5 110, 000. 22,000. 50, 000. 28,000. 21.2; 6 88,000. 22,000. 60,000. 8,000. 38.53 7 66,000. 22, 000. 70, 000. 8,000. +.5p 8 +h, 000 22,000. 80,000 58,000. 87.98 9 22 ,000. 2000. 90, 000. 68,000. 158.5” 10 —- 22,000. 100,000. 78,000. 354.5} TOTALS 8220,000. 8550,000. 8330,000. 716.8; PROP03.L H 0 8220, 000. q -- -- -- ..¢ 1 198, 000. 822,000. 873, 000. 851,000. 23.23 2 176, 000 22,000. 65,000. 83,000. 21.7” 3 15%, 000. 22,000. 57, 000. 35,000. 19.93 132,000. 22,000. #9 ,000. 27 000. 17.5; 6 88,000. 22,000. 33, 000. 11, 000. 10.0p 7 66,000. 22,000. 25,000. 3, 000. 3.ug 8 Ha ,000. 22,000. 17,000. (5,000.) ( 7.6%) 9 22, 000. 22,000. 9,000. (13,000.) (29.58) 10 -- 22,000. 1,000. (2.110(300) (SSQLI‘IJ) TOTALS 8220,000. 8370,000. 8150,000. (22.88) Eketurn on Initial Investment ROR = Average Annual after Tax Income + Initial Investment Proposal G R03 = $330,000 0 10 Proposal H ROR = $150,000 + 5 8220,000 8220,000 ROR = 15.0% ROB = 6.88 EEZEBrn on Average Investment .ROR = Average Annual After Tax Income + Average Investment EIOposal G ROR = 8 33,000 Proposal H R03 = 3 15,000 $110,000 8110,000 ROR = 30.08 R03 2 13.68 38 Each inflow represents in part a return on the capital outstanding during each particular period. The remaining amount is a return of a portion of the initial investment. The timing of the cash flow pattern is discussed in further detail below. Average Investment Variant The second major variant of ROB in use attempts to recognize the fallacy of including the total investment in measuring a rate of return.' This attempt is often made by dividing the initial investment by two to determine the "average" amount which will be in use over the pr0posal's life. Figure 2-1 shows Proposals G and H have average rates of return of 30% and 13.6% respectively. As should be expected, this approach also results in the erroneous accept- anpen of Proposal G. The respective rates are merely cioubled by determining a so-called "average” investment for 'the proposals. While this variant may be some improvement (aver the preceding one, it is subject to most of the same lDasic fallacies and a few of its own which are unique. Egaarly Book Value Variant The other principal approach to a determination of R03 airtempts to recognize the influence that profits in specific yEuirs can have on prOposal evaluations, and the problem of a (finange in the amount of investment involved each year. This is typically done by calculating yearly rates of return based 39 on.book values. Figure 2-l includes the yearly rates of return for Pr0posals G and H. These figures are virtually Ineaningless under most circumstances. They are seldom measures of comparability or profitability. Such nonsensical rates as 35H.5% and -95.43 shown in Figure 2-1 often result. It is difficult to discern how these figures could be very useful for project evaluations over a period of years. Rates of Return--Practice Table 2-1 indicates a total of twenty-seven firms utilize some variant cfi‘ ROB in their capital-expenditure decision-making process. Nineteen firms use this approach as a primary criterion and eight use it to supplement other criteria being employed. Some of the firms in the latter (category are in the process of phasing out the use of R03 entirely. QLpitial Investment Variant Slightly less than one-half of the firms using R03 ennploy this variant. Several of the executives in these fhirms indicated the approach is considered a measure of Irrofitability and comparability for ranking alternative idlvestment proposals. The validity of this assertion depends CHI how closely the measure approximates the results determined tar the internal yield criterion. The following comments are a condensation of a more detailed consideration of this line no of reasoning set forth by Lerrett and Sykes.lo The relationship between this variant of EUR and the true internal yield depends on the length of an asset's life, the nature of its cash flow and book profit patterns, and the discount rate involved. Consider first the simple assumption of a constant annual net cash benefits pattern and no salvage value for a proposal being evaluated. The ROR for such a proposal will normally underestimate the IY, with the general exception being assets with relatively long lives extending beyond forty years. The rates of return for proposals with after- tax internal yields in the 6-10% range and expected economic lives of ten to twenty years usually underestimates the IY 'by 40-50%. Such a large margin of error can often result in zan incorrect ranking or choice between proposals. If uneven cash flows are expected this ROR variant (:an either substantially overestimate or underestimate the 'true yield. The results depend on the direction and rate of cflaange in the net cash benefits pattern. The initial invest- nuent variant generally discriminates against short-lived Eissets and assets with short payback periods when cash flow Exitterns are changing. This discrimination results from Elssigning the same weight in the evaluation process to all (Rash flows regardless of the date received. The paradox of * loherrett and Sykes, pp. 220-226. 41 this situation is that a payback criterion will result in a higher and higher ranking for a project as its cash inflows are accelerated to earlier years. This same acceleration will result in the ROR variant increasing the discrimination against the project in favor of longer-lived or longer paying-out projects being considered. Most of the firms using ROB variants also utilize payback calculations for evaluating proposals. These firms may frequently obtain contradictory results from their two primary acceptance criteria. Several companies calculate an average return on initial investment for a period shorter than the expected economic life of a proposal, such as five, eight, or ten years. Although this effort to emphasize the near term and to discount the more distant cash flows may be worthwhile, the difficulties mentioned above are still not resolved successfully. Averaging the annual cash flows still results in discrimination between proposals, and the initial invest- .ment issue is skirted. In addition, even though the distant .flows are heavily discounted by the theoretically correct znethods the flows for this period should not be ignored ccnnpletely as occurs in the above ROR variation. The dis- cnissions in the next three chapters will show that such a Funactice could be particularly troublesome when terminal VWIPking capital flows, receipts from salvage, and other lxuxmne tax factors are involved in investment proposals. #2 Average Investment Variant Approximately one-fourth of the firms visited use this variant of ROR. The factors influencing the extent to which this variant approaches the true internal yield of a project are the same as those outlined above, but the directions of discrimination are typically the opposite and the true yield is normally overestimated. This ROR variant raises the likelihood that a firm will accept pro- posals that have prospective yields below the cost of capital. Yearly Book Value Variant Six of the firms visited compute a return for the first year of operations based on initial year investment. This procedure may under special circumstances be a proper measure of ranking proposals for comparability, but it does not measure profitability. A few other firms pick an expected typical year following the project's Shakedown period and either relate the annual profit to the capital outstanding ‘that year or to initial total investment. To the extent that 'these figures are actually representative of the total life :span of the proposal these measures may be used for compara- Ixility purposes. True profitability is not measured because time time value of money is ignored. However, it is doubtful tluat project comparability will always yield correct ranking lusing these techniques. The cyclical nature of the opera- ticuns of some of the firms and industries represented may Offxen preclude any single year from being representative of L+3 the results that can be expected for the entire economic life of many capital projects. One of the reasons cited for using the BOB variants is the belief that they measure profitability. This is a basic fallacy under most circumstances and has been refuted time after time, but the idea still persists. The examples in this thesis indicate once again that this method just is not a measure which can generally be used reliably to deter- mine profitability for capital projects. Probably the principal advantage cited for the use of ROR in the firms visited is the concept's simplicity. This contention is a gross oversimplification. 'The special assumptions necessary for the variants of ROR to always result in correct accept-or-reject decisions just do not square with reality. The principal disadvantage of the method is its apparent simplicity. The actual computations can be simpli- fied by ignoring numerous factors, but this will not alter the basic concept and the inherent rigid assumptions that are necessary for correctly determining these so-called rates of return. Several of the executives representing firms that lltilize one of the ROR variants complained that some of the criticisms leveled at the method are not valid because projects are not usually ranked in the way textbook or business Periodical examples often imply. This point may be the reason that the flaws of ROR are not more readily discernible 1+4 in practice. Very few companies actually ”ladder” all proposals at one point in time for the approaching invest- ment period. They should not necessarily be expected to do so. The interviews revealed that mest prOposals are initially considered in conceptual form only. In the early stages of the decision-making process an accept decision is often tentatively made with the expectation of final approval and expenditure of funds for the project occurring later in the year. As other proposals arise during the year they may or may not be presented to certain levels of management depending on the circumstances. This approach is also as should be expected. No firm or its personnel is endowed .with perfect foresight. The point at issue is that any acceptance criteria used should give consistent and correct results over a period of time regardless of the level of personnel making the decision, and irreSpective of the par- ticular items involved in the individual proposals being evaluated. These results cannot generally be expected from the use of rate of return calculations. It may be that the reason some firms do not yet recognize the possible existence of erroneous or discriminatory elements is because the normal decision-making process occurs continuously throughout the Year. Several of the firms that were visited utilize an ROR criterion computed on a before-tax basis. Although the examples in the succeeding chapters will indicate some of the discriminatory elements which can result from this kind ”5 of approach, one comment is relevant at this point. The rigid assumptions mentioned earlier regarding the use of ROB as a profitability measure preclude any such claim for the method if it is computed on a before-tax basis. It still can be a measure of comparability, but the necessary circum- stances and assumptions make the likelihood rather remote. RecoveryAPeriod--Theory The financial manager of a business firm has been aptly depicted as sitting on the horns of a two-pronged dilemma-~maintaining a sufficient reservoir of cash to meet currently recurring obligations and putting funds to work to maximize the present worth of future earnings.11 The acceptance criteria discussed thus far in this study have been mainly concerned with the latter objective of profit- ability. The liquidity objective is usually emphasized by firms through the use of a payback or recovery period criterion. The traditional definition of this criterion stresses the necessary time period required for a firm to recoup the investment in a new project. The following illustration will facilitate discussion of the recovery period measure. Illustration II-3 Assume the initial outlay expected for a new asset is $50,060 at time zero. Annual net cash benefits of 11Robert W. Johnson, Financial Kanagement (2d ed.; Boston: Allyn and Bacon, Inc., 19523, p. 20. 46 ¢12,000 are expected for six years. This information is shown on the time scale below. (50,000) 12,000 12,000 12,000 . . . 12,000 / l I / J. 7 I 7 I 7 to t1 t2 t3 L o o 0 t6 The time period that is necessary to recover the $50,000 investment is h.l7 years. Calculations are shown in Appendix B. This acceptance criterion shows over what period of time the investment in a project is at risk. The RP computation should be based on the same cash flow concept utilized for the three correct profitability measures dis- cussed earlier in this chapter. The RP criterion is not a measure of profitability. Proposals can be ranked in terms of liquidity if the criterion is correctly computed. The RP measure is usually cited as a way of determin- ing how long it will be before a firm has broken even, or is as wellcflfiTas it was before a proposal was adopted. The project in the preceding example will usually be said to have ”paid out” in #.l7 years if the expectations are correct, but ‘there is a fundamental error in this approach to the recovery 13eriod. One crucial element of cost is ignored in the compu- ‘tation. Recurring cash disbursements for operating outlays 21nd.the initial investment are the costs which must be irecouped to break even according to the traditional view. Ihvwever, before a firm can truly be said to have broken even 47 on a project some consideration must be given to its expected cost of capital. Two basic views may be taken in regard to the cost of capital. The amount of profits foregone by not investing elsewhere is one approach that can be taken to derive a firm's cost of capital. This View is called the "lending rate" or opportunity cost of capital concept. Alternatively, the eXplicit costs that must be paid to the suppliers of capital canflalso be taken into account in project evaluations. This "borrowing rate" concept of the cost of capital opens the door to many of the ramifications of financial leverage.1? However, the issue of leverage is skirted here and a common equity cost of capital is assumed for the purpose of continuing the discussion of Illustration II-3. By assuming a common equity cost of capital of 10%, a.recovery period of 5.7 years results for Illustration II-3. (3alculations are shown in Appendix B. This approach to the :recovery period certainly casts a different light on project ervaluations. Whereas the traditional approach yielded a relatively favorable RP of l+.l7 years, the 5.7 years period resulting from consideration of the cost of capital should cause a much closer look at the proposal in view of its 6-year life. It has been suggested that this approach to a recovery period could be used to gain top management's ¥ 1PFor a lengthy and comprehensive example of this Version of the recovery period and some of the influences ‘1? financial leverage see Merrett and Sykes, pp. 200-209. Both the lending and borrowing rate approaches are used in ,fiubsequent examples in this thesis in conjunction with the pgrofigeigive" recovery period approach that is discussed on H8 acceptance of the internal yield or some other discounting measure.l3 If a firm is currently using the traditional RP approach, the first step would be the introduction of ”RP plus interest or the cost of capital." It is then only a short step to show that the internal yield is the rate a firm earns for a recovery period equal to the length of a project's life, and that the excess of this yield over the cost of capital indicates profitability. The yield for the proposal in Illustration 11-3 is approximately 11.55. The proposal may alternatively be viewed as though the firm will break even over a six-year period if the cost of capital is 11.5%. Recovery Period--Practice Thirty-four of the firms included in the study use some measure of RP for evaluating capital-expenditure pro- posals (Table 2-l). Nineteen of these firms utilize the rapproach as a primary criterion. host of the other companies Ilse RP to supplement one of the discounting techniques or an 120R variant being used. Two of the companies interviewed explici ly include a (iharge in the recovery period computation which is considered tCD be an approximation of their cost of capital. One firm Irtilizes a weighted average "borrowing rate" concept. AIlother firm that uses RP as its primary criterion includes ¥ 132-Dig... , pp. 208-2090 l+9 what is essentially an Opportunity cost of capital in evaluating projects. This firm calls the measure a ”pro- gressive” payback calculation. As stated in the instruc- tions manual of this firm, the following question is raised in evaluating alternatives: "What is the minimum time we have to operate with the new project in order to get our investment back, and in addition, earn a return on the un— recovered portion of it at our objective earnings rate?" Tables have been prepared by this company to show the mathe- matical correlation between the traditional RP computed on a pre-tax basis and the "progressive" recovery period. These tables allow project originators to determine quickl what the approximate ”progressive” RP will be without making all of the necessary computations. The firm has effectively incorporated uneven cash flow problems resulting from work- ing capital changes, accelerated depreciation, investment credit allowances, and other factors into the correlation tables. A ”mixed progressive payback” calculation can be (ierived when assets with varying lives are included in a laroad capital investment program that is being evaluated. CPhis modification of the theoretical approach to RP that was (iiscussed in the preceding section has proven quite flexible axzcording to the controller of this firm. The method com- lxines some elements of the discounting procedures, and pro- ‘Khies information about project recovery periods while renxaining relatively free of computational problems. 50 Several of the firms visited consider the cost of debt financing in their determination of when a new project is eXpected to break even. Several other firms utilizing the RP method consider an imputed cost of equity funds when large projects are evaluated. Executives in the rest of the companies in which RF is used as an acceptance criterion stipulated that financing is an entirely separate problem and should be treated as such in evaluating capital-eXpenditure preposals. The latter approach is definitely erroneous. Solutions to the problems of making optimal investment decisions and obtaining the optimal sources of funds must be derived simultaneously. These solutions have not yet been generally derived in the theory or practice of financial management. Irrespective of how it is computed, some charge for a firm's cost of capital is necessary for a proper determination of the recovery period of a new project. The computational simplicity resulting from excluding such a charge may be attained only at the price of errors in decision making and lower profits. Certain inconsistencies exist in practice in the consideration of the cost of capital in RP calculations. The firms mentioned in the preceding paragraph that consider only equity costs are clearly in error unless no financial leverage is being employed in their capital structures. Several firms consider some costs of capital in evaluating fOl'eign projects, but ignore the factor entirely for domestic investments. This calculation places a penalty 51 on investing in foreign countries, and is not a proper pro- cedure for handling the higher degree of risk inherent in such projects as was contended by some firms. The recovery period approach is often considered to be a measure of risk in the evaluation of alternatives. The only risk measured is of a catastrophic nature, and from which a project would cease operations entirely after the recovery period. This kind of risk exists in certain industries where there is a high degree of potential obso- lescence, and in some foreign countries where politically unstable governments exist. A further evaluation of the RP approach as a measure of risk is set forth in Chapter V. Several prOponents of RP stipulated that the measure approaches the true yield of a project under certain condi- tions, and is a short cut to approximating profitability. If a proposal results from a short pre-revenue stage, has a relatively constant cash benefits pattern, and a life that extends beyond ten years, the reciprocal of the t aditional RP is a relatively close approximation of IY. This relation- ship is altered somewhat when the cost of capital is con- sidered in project evaluations. Furthermore, when a project has the characteristics listed above that are necessary for the traditional RP to be a short cut the calculations of IY and KPH are also moderately easy to derive. Except for the ”progressive” modification discussed at length above, the a} criterion does not offer any material assistance in the \71 [‘0 evaluation of capital-expenditure proposals that cannot be almost as readily determined through the utilization of the discounting techniques. Return on Sales The executives interviewed in two of the firm included in the study stated that a percentage return on sales is an important criterion. This measure is the primary mathematical acceptance criterion in one of the firms visited (Table 2-l). The same firm also utilizes an average rate of return on initial investment and the tra- ditional recovery period method in the evaluation process, but these criteria are weighed less heavily than the return on sales computation. Executives in both of the companies indicated the terminology and emphasis in their particular industry was on sales, and they felt the return on sales measure properly indicates profitability. A consideration of profit in relation to sales dollars has definite major flaws. The primary error results from ignoring the time value of money in the evaluations of capital-expenditure proposals. This factor is certainly not insignificant as two executives contended. The second Crucial flaw is that one of the two determinants of a ‘Droject's profitability is ignored. Profitability of a Capital-expenditure proposal depends on the operating margin on sales and the turnover rate(s) of the asset(s) involved. 53 To the extent that differences in asset turnover rates exist for various kinds of investment proposals in the firms utilizing this approach, substantial errors may be made in deciding between profitable uses of funds for capital projects. Other Measures An unusual criterion was found in use in one of the .firms visited in the field study. The measure is based on an effort to recognize the high degree of technical effi- ciency which exists in many of the operating divisions of ‘the firm. Although the criterion appears to be quite useful £13 a basis for comparability of technical efficiency between (livisions, it does not measure the profitability of capital- eXpenditure projects. Two important errors are apparent :from.a profitability measurement viewpoint. The time value (bf money is intentionally ignored in the use of the criterion. {The executive interviewed in this firm stated that the :Lnternal yield approach is being used in two of its operating (iivisions, but that this discounting approach has not resulted 111 the acceptance of any proposals that would not have been laccepted anyhow. This argument cannot be refuted, but it is not necessarily germane. The relevance of this comment depends on the extent to which projects would be accepted irrespective of the nature of the acceptance criterion in use . 51+ The other fundamental error in the measure results from a failure to relate the benefits calculated for a project to the total assets from which they are expected to result. This criticism was also leveled against the return on sales measure discussed in the preceding section. Sumrta r}: The purpose of this chapter has been four-fold. First, the theoretical basis for each of the mathematical acceptance criteria found being used by the firms inter- viewed was discussed briefly. Second, the number of firms in the study which use the various criteria was set forth in Table 2-l. Third, the general patterns of reasons given by the firms regarding utilization of each criterion have been stated. Fourth, an effort has been made to relate theory to practice and the reasons for practice, and to point out consistencies and inconsistencies between their interrelationships. Three theoretically correct general measures of profitability were discussed initially in the chapter. These measures are: net present worth, internal yield, and uniform annual charge. It was noted that the latter method has perhaps received insufficient attention in financial manage- ment literature. The other acceptance criteria discussed included the LAPI formula, so-called Rates of Return, Recovery Period, and Return on Sales. The principal finding stated in the chapter was the gradual, but distinct, shift toward the utilization of the time-adjusting or discounting acceptance measures avail- able. Three-fourths of the fi ms in the study are currently using one of these methods, and several others are consider- ing changing to th m in the near future. Lore than forty percent of the firms visited are utilizing a discounting technique as a primary evaluation criterion. host of the other firms are using the internal yield approach as a criterion for major or special projects, and expect the usage to spread to other types of proposals eventually. The internal yield method was decidedly favored by the firms in the study over the other theoretically correct measures. The principal reasons given by firms for not utiliz- ing the time-adjusting methods at all, or at least more extensively, were stated and evaluated. These reasons are related to the degree of competition in the various indus- tries, the quality of the quantitative data in the capital- expenditure proposals, capital rationing and excess liquidity conditions experienced by the firms, and educational and orientation problems with personnel. Upon critical evaluation, most of these reasons were found to lack substance Or were inconsistent with other practices followed by the firms. The LAPI system was discussed briefly, but was found in use in only one firm. One of the principal reasons for the technique's lack of popularity seems to be an insuffi- 56 cient evaluation of its relative merits by the firms in the study. Three so-called rate of return variants were discussed and criticized. Although over sixty percent of the firms are using one of these variants, some of the interviewees stated they are phasing out their current usage of the technique. The variants were shown to discriminate against the very projects often most desired by business firms--short—lived assets and others with short recovery periods. The recovery period method was found to be widely ‘used, but appears to be losing some of its stature. The traditional view of a recovery period was challenged in the chapter, and a "progressive" measure found in use in one firm was suggested as a more desirable analytical tool. Two other criteria which do not measure profitability ‘were discussed briefly in the chapter. Both of the criteria ignore the time value of money, and also fail to relate total project benefits to the total assets being used to generate them. CHAPTER III FEDERAL IN OLE TAX INCENTIVE PROVISIONS The first major effort by the U. S. Congress to pro- vide business firms with an incentive to invest in plant and equipment after the Korean War was the passage of new laws allowing accelerated depreciation of the cost of long- lived assets. The 1954 revision of the Internal Revenue Code included the first formal allowance of two new methods of depreciation--the sum-of—year's digits and declining- balance procedures. It was not until eight years later that other important measures were enacted to provide additional investment incentives. These later measures were the investment credit provisions of 1962 as amended in 196%, the guideline depreciation system introduced in 1962, and the income tax rate reductions effected in 1964 and 1965.1 The incentive effects of the three recent measures on 1An additional 20% first-year depreciation allowance became available in 1958 under Code Section 179, but was primarily for the benefit of small firms and was not con- sidered important by any of the firms visited. For a dis- cussion of this provision see 1965 Federal Tax Course (New 'York: Commerce Clearing House, Inc., 196%), pp. llfil-llh3. .Another less important incentive measure is Code Section 167 (f), which allows a firm to ignore up to 10% of an zasset's cost in estimating salvage value to calculate annual (depreciation. This provision is discussed briefly in Chapter IV of this thesis. 57 53 individual capital projects are first discussed separately in the pages that follow. The possible combined theoretical incentive impact is then examined for various hypothesized cases. These sections are followed by an indication of the practices found in the field interviews and the reasons related by firms for following the practices. Prior to considering the effects of accelerated depreciation on individual investment projects the possible incentive in- fluences of a greater supply of investable funds stemming from the three newer incentive provisions are examined. A theoretical approach for incorporating the supply of funds effect into the decision-making process is also set forth. The Tax Saving Concept Income tax provisions have a dual impact on the economic evaluations of capital-expenditure proposals. First, nearly all tax provisions influence the amount of net cash benefits resulting from investment projects. This influence gives rise to the concept of a tax saving. Second, the timing of net cash flows resulting from investment out- lays varies significantly depending on different income tax provisions and circumstances encountered by business firms. TThe crucial importance of timing is examined later in this chapter. Federal income taxes in the United States are based onltaxable income rather than gross income. Current operat- ing disbursements are deductible from gross receipts in the \71 \O derivation of taxable income, and income taxes are deter- mined annually by applying the tax rate to taxable incone. Illustration Ill-1 Assume estimated gross receipts and disbursements for a project amount to $1,000 and $400 respectively for a certain period of years, and that the tax rate to be applied is HBfi. The after-tax net cash benefits will equal $312, and are calculated as shown in Appendix B. If taxes had been based on gross income the net cash benefits would have amounted to @120. It is thus apparent that a tax saving of 3192 results from the deductibility of cash disbursements for Operating expenses. This saving can be derived by multiplying the 48} tax rate times the QQCO disbursement. The federal government is accordingly viewed as sharing in the fortunes of business firms only to the extent that receipts are not offset by disbursements for current expenses. The concept of a tax saving needs to be taken one step .further. Depreciation of long-lived assets is also allowable las a deduction for Federal income tax purposes. If the illustration above is continued by assuming the receipts and (iisbursements are related to an asset costing $1,500 with an EBXpected useful life of ten years, and no salvage value is EBircpected to exist, the annual net cash benefits after income 'taxes would amount to $384. 60 The cash flow pattern for this capital project is shown on the following time scale, and the separate tax savings are shown for both the depreciation and cash ex- pense deductions. This type of presentation will prove useful in subsequent discussion about tax depreciation policies of business firms. Depreciation savings Expense savings Initial investment 72 Benefits excluding 72 192 tax savings 192 (1,500) 120 . . . . . . . . . 120 / / <% t0 t1 t10 The concept of a tax saving and certain related timing consequences provide the bases for the discussion of all of the income tax factors examined in the remainder of this thesis. The basic concept set forth in the preceding para- graphs will be elaborated on and expanded throughout much of ‘the discussion in subsequent chapters. A mathematical formu- ilation.of the tax saving concept is presented in Appendix A. Investment Credit--Theory The Revenue Act of 1962 as amended in 1964 allows a <2redit against the annual Federal income tax of up to 73 of 61 the cost of a corporation's investment in ”Section 38” property acquired in taxable years ending after 196l.2 Section 38 property essentially includes tangible personal depreciable or amortizable prOperty that is used as an integral part of the business Operations of a firm. Although up to $50,000 of the cost of used Section 38 property may qualify for the credit each year, the provision relates primarily to new asset acquisitions. Buildings and structures, except elevators and escalators, are explicitly excluded from qualifying as Section 38 property. Property used predominantly outside the United States does not qualify, except for certain transportation service equip- ment. The credit is allowable for the first year that the property is placed in service, but is limited to the amount of the total tax liability or $25,000 plus 25; of the liability if it exceeds $25,000 for the year. If the credit exceeds the maximum limit for a given year it may be carried back three years and over five years with certain limitations. The full 7% credit is allowable only on assets with tax lives of eight years or longer.3 Two-thirds of the credit is allowable for assets with lives of six but less 'than eight years, whereas one-third of the credit is allow- Elble for assets with lives of four but less than six years. 21bid., pp. 613-615. 30nly 3/7 of the credit is allowable for Section 38 acquisitions by public utility companies. 62 The relative influence of the investment credit on individual proposals depends on several factors that are discussed throughout the thesis. The primary factors are the pre-tax earnings pattern of an asset, its depreciable life, the method of depreciation used, any expected salvage value, the size of the income tax rate, and how the asset is to be financed. A series of cases hypothesized by George Terborgh includes financing considerations, and is k A single summarized in a later section of this chapter. example of the influence of the investment credit on the desirability of a new proposal will suffice for current purposes. The example is based on the assumption that no financial leverage exists in the capital structure of the hypothetical firm. Illustration III-2 Assume the net cash benefits for a proposal requiring an initial investment of $10,000 are estimated as shown below on the time scale. To illustrate the influence of the credit under the conditions that existed at the time it was first enacted into law, a 52% income tax rate is assumed. (10,000) 2,013 2,013 2,013 . . . . 2,013 { / / / _g/ 0 t1 t2 t3 0 O O 0 t8 1+George Terborgh, Incentive Value of the Investment Credit,_The Guideline Depreciation SyStem, and—the‘Corporate ,flgte Redugtion (Washington, D.C.: Machinery and Allied Products Institute and Council for Technological Advancement, 196%). 63 The internal yield on this prOp sal is exactly 123, and is calculated in Appendix B. Assume next that the asset qualifies fully for the 7% investment credit, and that this amount is treated as an immediate cash inflow as shown on the time scale below. Investment credit Initial investment 700 Nefi cash benefits (10,000 2,013 2,013 2,013 . . . . . 2,013 ' f: ‘f’ / f / to t1 t2 t3 0 o o o 0 t8 Because of the 5700 investment credit the yield will now amount to approximately 1%.25, or an improvement of about 18} over the original yield. This enhancement is certainly substantial, and especially if the project being:eva1uated is otherwise of marginal desirability. Even if the benefit of the credit is not recognized until the end of the first year of operation of the asset the yield is still nearly 1h%. The traditional and progressive recovery periods for the project are approximately 5.0 years and 7.5 years if no consideration is given to the investment credit. By con- sidering the investment credit as an immediate cash inflow the new recovery periods are H.6 years and 6.5 years. The calculations shown in Appendix B are based on a 10$ cost of capital. These improvements are roughly 7} and 13$ respec- tively. One additional point regarding the investment credit is relevant at this juncture. If an asset is not held for the entire eight~year period some portion of the 7$ credit that has been taken must be repaid to the government following the year of asset disposition. The repayment equals the difference between the credit taken and the amount that would have been allowed if the computation had been based on the shorter period. If it is expected at the outset that the firm will not keep the asset for the entire eight-year period, the full credit should be taken and a negative cash flow should be included in the calculation for the repayment expected following the year of anticipated disposal. If the asset is disposed of as predicted, the firm will have returned some portion of the credit without being charged interest by the government for the period in- volved. If the asset is subsequently kept beyond the eight years, the firm will have been able to obtain the full benefit of the 75 credit. This benefit is not obtainable retroactively after it has been determined that the asset life has been underestimated and that only a portion of the credit was taken. Corporate Tax Rate Beduction--Theory The Revenue Act of 196% provided for a two-step reduction in the corporate income tax rates. Prior to 65 January 1, 196%, the normal rate onzll taxable incone was 305 and the surtax rate was 22} on all taxable income over $25,000. The combined statutory rate on all taxable incone over 325,000 was thus 52}. For tax years beginning on or after January 1, 1965, the normal rate is 22; on all taxable income and the surtax rate is 263 on all taxable income over $25,000. Comparable rates for 1964 were 22; and 23; respectively. Since nearly all of the firms included in the study had sizable taxable incomes, the rates used for "before” and ”after” comparisons in subsequent illustrations are 52} and 485. It is recognized that the effective tax rates are often less than these percentages because of Operating and capital losses, state and foreign taxes, consolidated returns, and many other factors. Several of these factors are discussed in Chapter V. Illustration III-3 Assume the cash flows shown on the time scale below are on a pre-tax basis. If these cash flows are reduced by a tax rate of 52$, the annual cash benefits amount to $2,013. It was mentioned in the preceding section that the internal yield on this cash flow pattern equals 12}. , / 1 / 1 / I 7 I I 7 t t t t . C . O t 66 If the pre-tax flows of $4,193 are reduced by the 48% income tax rate effective for 1965 and thereafter, the yield is roughly l’+.1+%. This improvement in yield is comparable to the results calculated for the investment credit allowance on the project. The after-tax net cash benefits amount to $2,180 annually. After giving effect to the income tax rate reduction of #35, the traditional and progressive versions of the recovery period measure are l+.6 years and 6.5 years. The latter calculation is based on a 10% cost of capital. The size of the improvements from the tax rate reduction are also comparable to the results obtained from the investment credit in the illus- tration on page 62. All calculations are shown in Appendix B. A note of caution is needed at this point. It was stated in the preceding section that the influence of each of the incentive provisions depends on several factors. In the results derived by Terborgh's illustrations shown in a subsequent section the investment credit has a much greater incentive influence on individual proposals than the tax rate reduction and the new guideline procedures combined. The principal reasons for the differing results are the declining earnings and depreciation patterns assumed by Terborgh. These assumptions substantially change the relative impact of the three incentive provisions, and provide excel- lent examples of the dangers in generalizing about their influences. Every business firm should evaluate each project 67 and the influence of the different incentive provisions on that project relative to other investment outlets, each of which may have similar or entirely different characteristics. Terborgh's illustrative cases are no less or more valid 5 than those assumed here. Before proceeding to a discussion of the guideline system, one additional comment about the impact of the iJncome tax rate reduction is needed. The rate reduction zipplies to all taxable income from existing as well as new zisset acquisitions. The relative ranking of a new asset versus an asset currently in use may not change tsubstantially from the rate reduction. The absolute net (sash.benefits after taxes from both assets will increase, tuit it must not be assumed that the substantial improvement 1J3 the internal yield of the new proposal assures its acceptance. Furthermore, the greatest influence from the tax rate reduction undoubtedly results from the increased snapply of funds made available for investment by reducing ‘tlne necessary tax outlays on all taxable income. This factor 11:3 examined in a later section of this chapter. Depreciation Guidelines and Rules-~Theory The rules governing the depreciation guideline system are set forth in Revenue Procedure 62-21 which was introduced 5One exception to this comment has already been noted. Terborgh considers the influence of financial leverage in the evaluation of investment prOposals. 68 by administrative action in 1962.6 Guideline lives are specified for approximately seventy-five broad classes of assets. These rules and guidelines supersede the detailed listings of individual asset lives in old Bulletin F. The guidelines do not supersede existing arrangements or previously established procedures by firms that prefer to continue their use. Depreciation within the guideline classes is determined on a group or composite basis rather than on individual assets. The principal objectives of the guidelines were to shorten asset lives for tax depreciation purposes and to simplify the vast amount of record-keeping for individual assets. A "reserve ratio test" is also included in Revenue JProcedure 62-21. This test requires a determination of \vhether individual firms are utilizing appropriate rates for <2alculating tax depreciation on assets in each guideline <21ass. The depreciation reserves for guideline classes are <2ompared with, or tested against, the total cost of the zassets to determine if their percentage relationship falls Evithin certain test ranges that have been pre-determined by 'the tax authorities. This test was supposed to have been Eipplied after three years of guideline use. The application (of the test has not yet occurred and has currently been post- 61965 Federal Tax Course (New York: Commerce Clearing Iflmzse, Inc., 196%), pp. llO9-1137. The guideline procedures are discussed extensively in this source. 69 poned indefinitely. Whereas the investment credit allowance applies evenly to the cost of Section 38 acquisitions by business firms,7 and the tax rate reduction enhances after-tax income of all assets in existence and being evaluated, the guideline system has a widely varying incentive impact. .Although the average reduction in depreciable tax lives was approximately 15% for all U. S. firms, many companies re- ceived practically no benefits because their existing rates ‘were already below the guidelines. Other firms have benefited greatly as is elaborated on in the practice section below. It is thus once again imperative to recognize the dangers in generalizing about the influences of the incentive provisions. TThe following illustration indicates the influence of the guidelines only on the relationships hypothesized and should Inot be generalized. Illustration III-4 Assume that in 1961 a firm was considering the acquisition of an asset costing $14,300 that was expected to provide estimated annual cash benefits of $1,820. Assume further the income tax rate was 52%. A zero salvage value estimate was expected, and straight-line depreciation was to be used for 7This comment is subject to the qualifications mentioned on page 61. 70 tax purposes. The cash flow pattern which would result from these assumptions is shown below. (in,300) 1,820 1,820 . . 1,820 1,820 1,820 l I I 7 / t fl‘\ 0 O / / 0 t1 2 t11 t12 t13 The internal yield on the proposal is 8.1%. The pro- ggressive and traditional recovery periods are 11.8 years and 77.9 years respectively. The progressive measure is based on a cost of capital rate of 7%. Assume next that the depreciation guideline procedures laave just been made available, and that the tax life for the (:lass to which this asset belongs has been shortened to eeleven years. This reduction is roughly equal to the 15% arverage for all U. S. firms that was mentioned on the previous Image. Since the economic life of the asset has been hypothe- sized as thirteen years and the tax life is now eleven years, ‘tlne depreciation allowances over the guideline life will be iixacreased. The higher depreciation allowances for the guide- lgine years result in zero allowances in t1? and t13. Cash tnenefits would then amount to $1,92h and $1,2h8 for the Periods t1 through tll and t1? through 1513 respectively. The internal yield on the project is 8.5% and is a twalative improvement of only 5% over the 8.1% yield determined before the guideline procedures were being considered. Calculations for the project are shown in Appendix B. The preceding illustration indicates that the guide- lines may have decidedly less incentive effects on evaluations 71 of capital—expenditure pr0posals than the investment credit and tax rate reduction. As is discussed in the guidelines practice section later in this chapter however, these results do not necessarily hold for individual firms or even asset classes within firms. Combination of Incentive Value--The0ry The cash flow pattern for the preceding illustration is shown below, and is based on the additional assumptions of a ABE tax rate and the availability of the 7; investment credit. The investment credit is shown as a positive cash inflow at to and amounts to $1,001. 1,001 (1%,300) 1.976 1.976 . . . 1,976 1,352 1,352 1. 1 7/ J / / After giving consideration to all three incentive provisions, the internal yield on the proposal is approximately 10.h$. This represents over a 29% improvement from the initial yield of 8.1%. It was shown in the preceding section that approximately 5% of this improvement is attributable to the guideline provision. This fact indicates the significance oi‘the relative influence of the investment credit and the ‘tax rate reduction on the hypothesized figures. The two recovery periods are approximately 6.7 years and 9.% years after giving consideration to the incentive measures. The improvements are 15% and 20$ for the tra- 72 ditional and progressive methods respectively. Whereas the progressive RP of 11.8 years exceeded the guideline tax life prior to considering any incentive measures, a greater margin of safety now exists that could be the deciding factor in eventual acceptance of the project. Since the preceding results relate only to a single asset, they cannot be generalized to apply to all new alternatives being considered by a firm. A series of hypothetical cases is examined in the next section, but is considered in terms of another mathematical acceptance criterion that has not been discussed in previous pages. LAPI-CTA Study-~The Equity Rate of Return Criterion A concise statement of the possible incentive values of the three tax provisions being discussed was completed recently by George Terborgh of the hachinery and Allied 8 Products Institute. This section is a summary of the find- ings by Terborgh in his analysis of a series of illustrative cases involving individual capital-expenditure projects. The test of the incentive value employed in the study is "the increase in the after-tax return on equity invest- Irent that results from the application of the tax measure / (or combination of measures) in question." Terborgh has zargued for years that the after-tax equity rate of return is the most relevant acceptance criterion to utilize in the 8Terborgh, Incentive Value of the Investment Credit, pp. 12-170 91bid., p. 12. 73 evaluation of alternative investment prOposals. He has been joined more recently by other writers who make a strong case for the validity of this approach.10 This author con- curs with the view that financial leverage should be given explicit recognition in the evaluation of individual capital projects. All of the examples considered thus far in this study have ignored the element of financial leverage in investment decisions and only the returns on all-equity cases have been examined. Terborgh's illustrations are reproduced in Figure 3-1, and consider both the all-equity case and a series of cases assuming a 1:2 debt/equity ratio. Figure 3-1 illustrates the changes which would result from considering each of the incentive provisions separately, and in total, if a 10% equity rate of return is initially assumed for all projects. Further important assumptions regarding the illustrative cases are listed below.11 The important conclusions stated by Terborgh are essentially as follows.12 loSee herret and Sykes, pp. 122-130. llTerborgh, p. 13. The principal assumptions are: (l) the pre-tax earnings of the assets decline at a constant rate to zero at the end of their service lives; (2) there are 110 terminal values for capital rojects; (3) sum-of-year's (iigits depreciation is used; (4? a 52% tax rate exists; (5) the investment credit is a cash inflow at t]; (6) interest charges on debt are 5% annually; and (7) an average service-life re- c. 8... 08?.“ ON n. o. 9:: _ _ fi‘_ _ _ _ L _ cSBGQRuQ one: ESQ ___:._ fi-FII ill. 1/ .85289tmsfirfiu kaxuatLMMWMllllll _ \. teases n ~— V... A 335 £3mé$ 388.. 2 a3 .— use... u. .52.“. ee 23: £5 .53. o... 8.5 £03.38 5. a: Go a... 5:83— 8...— ud. 2.. an 5 accepted 8:035 an a .580 .8582.— 3. an a is...» 25:: 51.5 595.2 g Hfiiafiu mo>HucooGH awe moiwczum «souHmoccur from the increased activity. The assump- titni:is often made that the working capital ratio is unchanged in the process of estimating accounts payable. This method is supposed to show the use of cash involved in the permanent increase in net current assets.6 Further- more, changes in net working capital should be shown as cash flows over the project's life. This approach to estimating working capital needs and changes is relatively easy to implement. In addition, it is generally consistent with the usual approach taken in calculating a cut-off rate with which the project's rate of return will be compared. Non-interest bearing current liabilities are usually ignored in calculating cost of capital cut-off rates. 3y netting such liabilities against current asset needs, they are effectively "counted" in the evaluation process. Conceptually however, there seems to be little logical basis for this type of distinction between short-term sources and uses of funds and those that are generally construed as being longer term in nature. A theoretically correct alternative for calculating the tax effects of working capital items is to project all cash flows in the future including leads and lags in receivables and payables. However, this procedure may often. 6 . . See Bierman and Smidt, pp. llh-llS, for an elaboration of this viewpoint. }_.J Ll) \l be exrtremely difficult and time consuming to implement for iauiividuol projects. The differences in results between these twainethods of estimating working capital may often be so snmll.that expediency would dictate the former being preferable. The examples in previous sections have indicated the present worth and total future wealth influences that can result from large early or terminal cash inflows or t _ outflows. Thus, nothing can be gained by additional illustrations for working capital influences which are similar in principle. The primary point that needs to be recognized here is the discrimination against projects involving working capital needs when compared with projects that do not involve such outlays. The latter category may be favored over the former, since funds are not tied up for long periods of time or subsequently being released on a dollar for dollar basis without any return on the invest- ment. The higher the cost of capital and reinvestment rates for such periods the greater the discrimination will be against projects involving outlays for working capital. One factor should be mentioned in favor of projects involving working capital outlrys. Since such eXpenditures will often be returned dollar for dollar the risk element inherent may not be as great as on a project involving fixed facilities all of which can become obsolete overnight. 138 werking Capital and Income Tax Effects--Practice As shown in Table h-Z, only three firms visited do not consider working capital explicitly as an addition to the funds invested in plant and equipment for a project. All three of the firms use non-discounting acceptance measures, and two of them evaluate projects on a pre-tax basis only. The executives interviewed seemed to be aware of the inconsistency involved in treating working capital and plant outlays differently in their evaluation processes. A lack of relevancy appeared to be the principal reason for this procedure, but total working capital investment was not at all insignificant in two of these firms. Another important problem in these firms has been the inability to allocate the total amount of working capital to specific projects. TABLE H-2 WORKING CAPITAL FACTORS CONSIDERED IN PROPOSAL EVALUATIONS Factors Firms WOrking Capital Considered as Capital Expenditure: 3; Gross current assets 18 Gross current assets minus current trade payables 18 Others 5 werking Capital Included in Recovery Period Derivation 32 [.4 L») \Q '1 .mighteen firms consider working capital on a gross lxasis twithcut netting payables against current assets. The prinmun/ reason for this policy is the conservatism involved in.sflunving the total commitments for a project. Several of tfluese firmm also utilized non-discounting acceptance measures, and the working capital items were not on a cash low basis. Approximately one-fourth of the firms interviewed ignore working capital in calculating the recovery period for projects. Uhile this approach is consistent with the theory of traditional recovery period calculations it is erroneous for progressive recovery period purposes. A firm cannot break even until all funds committed to a project are returned with a minimum yield being earned. Furthermore, no logical basis necessarily exists for ignoring working capital outlays for one acceptance criterion and considering them for others. Eighteen of the firms visited follow the practice of considering working capital on a net of trade payables basis. Several of the executives in these firms stated that to do otherwise would be inconsistent with their cost of capital cut-off rate calculations. In many of these firms working capital is considered only on rather large major projects. The primary reason cited for this practice was an inability to derive working capital flows for smaller projects even thoughiflmy'were often acknowledged as being relevant. Five firms either netted cash and trade payables or immned them entirely for evaluation purposes on the grounds lhO (of iflaeii? immateriality. This argiment obviously cannot be refuted. Capital Expenditure vs Current ”ya . 4—1.4- onse-- Theory and Practice Several options exist in Federal income tax regula- 'tions hat allow firms a choice as to whether outlays w 01-! Ill-L-L be expensed in the current year or capitalized and amortized over some future period. both the These options influence amount considered as initial investment and the future cash flow prttern for new projects. The following pages include a brief discussion of the theory and practices relating to some of these options. Research and Development The expenditures by business enterprises for research and development are often considered the wellspring of the long-term industrial growth in the United States. It can be argued that virtually all expenditures for so-called fixed plant and equipment stem ultimately from previous research endeavors. Code Section 17% provides firms with an Option to either expense such outlays immediately or to capitalize and amortize them over some future period.7 T‘ ne critical problem from a capital budgeting viewpoint is the inabtnty to relate specific benefits which can be expected 7For a discussion of Code Section l7h see 106 Fedemfl.Tax Course (New York: Commerce Clearing House, Inc.,19645, ppiw632-633- lhl to result, and the duration of these benefits, to specific dollars paid out for research. Only ten of the firms in the study evaluate any of their research proposals using essentially'the same acceptance criteria that are utilized for other'capital-expenditure proposals (Table h-3). It is significant to note that while approximately two-thirds of the companies in the study budget some or all research and development outlays separately from both the capital and operating expense budgets, only eight capitalize any of these costs for book or tax purposes. Most of the firms visited indicated the general line of reasoning stated above in discussing why research and development costs are not subjected to the same evaluation process as other capital expenditures. TABLE H-3 FACTORS EVALUATED AS CAPITAL EXPENDITURES Factors Firms Research and Deve10pment 10 Major Maintenance or Repairs 8 Major Acquisitions 2O Leased Facilities 38 Businessmen are often chided that the immediate write-off practices that were outlined above are ultra- conservative and do not properly reflect net income from a financial statement viewpoint. While this fact is hardly open to question in many instances, the time value of money almost forces the business executive to follow these pqmuitices. If a given outlay can be made for either of inns projects which would result in the same earnings lxafore taxes and cost amortization, and if one of these 'projects involves research outlays while the other is a deprecialfle asset, the latter alternative "a may be decidedly disadvantaged. Since under current tax rates H8$ of the research outlryvdll be recouped almost immediately, the presen worth of this project would definitely be favored over a depreciab e asset. However, it is probably more 11) important that the dollar investment remaining unrecovered (and thus subject to risk of loss) is substantially less for the research project and that the funds can be reinvested almost immediately in other projects. The total future wealth that could thus accumulate from the depreciable project may be substantially less than from the research Jroiect. Accordincl* it is often more desirable d U ’ to increase revenues through research and development out- c. n f lays than through plant and equipment expenditures. A note of caution should be sounded regarding this last point, however. If the benefits expected from a project are low in.early years and high in later years it may be desi able to have a cost to amortize against those that are expected im1the more distant future. The crucial factor is once ._v..) againtdmt can be done with the tax outlrys retained by :hmmdhflely writing off research and development expenditures. ll+3 The absolute statutory tax rate is an important factor that influences the relative advantage of research and development over tangible fixed assets. The present worth of immediate tax savings resulting from research and development writeoffs was decreased relative to the present worth of tax savings from depreciation by the 11% tax rate reduction effected in 1961+ and 1965'. The tax cut thus discriminates against research and develOpment outlays in general as compared with plant and equipment projects. This discriminatory element was not found to have importantly influenced decisions between the two kinds of outlays in the firms in the field study. Major Maintenance or Repairs Accounting theory holds that outlays made for repairs or maintenance which result in enhancement of the physical life or productive capabilities of existing assets should be considered a capital outlay and entered in the proper records accordingly. This treatment involves an estimation of the future service potential of the existing asset with- out the repairs, and what changes can be expected to result if the outlays are made. Another alternative in many cases is the disposition of the old facility and acquisition of a new one as discussed earlier in this chapter. In making such decisions, the extremely fine line between capital outlay and current expense often becomes blurred and indiscernible. The probable treatment by the tax authorities 141+ for these kinds of expenditures is a crucial element in the decision between alternatives. Table 1+—3 shows that eight of the companies that were interviewed consider major repair or maintenance decisions as an integral part of their capital budgeting programs. This type of outlay is subjected to essentially the same analytical process that other capital expenditures go through. This factor is definitely a strong point in the capital budgeting programs of these firms, and is a very desirable approach regardless of the tax implications. The alternatives in this area of decision making are inextricably interrelated, and should be treated accordingly irreSpective of the artificial separations sometimes attempted. Many of the firms visited seemed to agree with the idea that major maintenance decisions should be evaluated as indicated above, but have not generally made it a part of their normal capital budgeting routine. However, several companies have done so on large or unusual projects that occasionally arise. Other writings have indicated many of the special problems involved in replacement vs. repair type decisions, and have related what attempts business firms have made to 8 utilize appropriate techniques for solving them. 8Elly Vassilatou-Thanopoulos, Financial Analmsis Techni ues for E uipment Replacement Decisions, Research Monograph No. l ENew York: National Association of Account- ants,1965). This study reviews some of the theoretical problems involved in equipment replacement decisions and practices followed by a group of medium—sized firms in evaluating proposals of this type. ll+5 Innmmnmble tax factors including investment credit allow- ances, accelerated amortization, capital gains or losses, undepreciated tax bases, salvage values, and obsolescence losses are all possible crucial items in the evaluation of replacement projects. The influences of these factors on investment projects in general has been demonstrated throughout this thesis and further arithmetic examples are not necessary at this point. In fact, many of the previous examples involved replacement decisions although no particular emphasis was indicated at the time. It should suffice to note that the explicit recognition of the integral nature of the outlays for major maintenance or repairs in their capital budgeting programs should be carefully considered by business firms. The treatment of the multitude of important income tax factors that are typically involved would immediately need to be reconciled in the evaluation process. kajor Acquisitions The Federal income tax factors involved in the acquisition of existing business entities are sufficiently numerous and intricate that separate studies have been made ixi'this area.9 There were two principal points examined in the field study that are related to such acquisitions. First, an attempt was made to ascertain whether acquisitions 9J. K; Butters, J. Lintnerz and w; L. Cary, Effects of Taxation on Corporate Mergers Boston: Division of Research, Graduate School of Business Administration, Harvard University, 1951) . 1H6 are evaluated as capital expenditures. Second, the question was posed as to what income tax factors have generally been involved in an influential way in the decision-making process for such acquisitions. Table H-3 shows that slightly less than half of the companies whose practices were examined in the study evaluate acquisitions of other firms as capital expendi- tures. Twelve of these firms have acquired a few small companies over the past several years, and stated that tax considerations had no influence at all on the acquisition. Of the eight companies indicating that taxes were a factor, none would indicate that they were of major or over-riding importance. Several stipulated that tax provisions would be more important from the viewpoint of the seller.10 It was indicated in the rest of the firms that acquisitions have been immaterial in recent years. The primary item specifically mentioned as having any bearing on major acquisitions involved the excess of the purchaser's cost over the book value of the assets as carried on the seller's books. If the excess is assignable to tangible assets, its subsequent amortization is generally acceptable to the tax authorities. If the assignment is to certain intangible assets, particularly goodwill, amortiza- tion for tax purposes is seldom possible. The financial influences of these tax consequences have been elaborated 19121Q., p. 27. These comments corroborate the findings of the earlier and exhaustive study of the above noted authors. 1%? on at length in financial and accounting literature.11 The only other factors mentioned by a few firms were operating loss carryovers that might be used by the purchaser, and the ability of the seller to engage in a tax-free exchange for the assets or stock given up. Both of these items can influence the bargaining position and subsequent final price if the transaction is effected. Interest, Taxes, and Carryigg Charges Code Section 266 allows the taxpayer the option to capitalize certain outlays for interest, taxes, and carry- ing charges if they are in fact in the nature of capital expenditures.12 The firms interviewed in the study seldom select the capitalization option. Only four firms capital- ize such outlays on an occasional basis. The principal reasons given for not doing so vvere a general lack of relevancy, and the immediate tax savings from expensing such items. Leasing and Income Taxes--Theory Numerous articles have been written in recent years in which lease financing arrangements have been examined in llArthur R. Wyatt, A Critical Study of Accounting for Business Combinations, Accounting Research Study No. 5, (New York: American Institute of Certified Public Accountants, 1963) 12See the discussion of these factors in 1265 Federal Tax Course6(New York: Commerce Clearing House, nc., , pp. 533-53 . lh8 a rather penetrating fashion.13 It is now generally recognized that lease rental payments include at least two fundamental elements: charges for the use of the asset and charges for the use of the capital of the lessor. Much has been written concerning the proper method(s) for recognizing these two elements separately in the decision- making process, and of subsequently calculating a yield or rate of profitability on a leased project. Three approaches to leasing evaluations and the basic tax considerations involved are set forth in the following pages. Consider the example below. Illustration IV-k Assume a project is being evaluated which would entail lease payments at the end of each of eight years that amount to $100,000. The project is expected to earn $200,000 annually before consider- ing the lease payments and taxes. These facts are shown on the time scale below. Lease payments Cash benefits before lease payments and taxes (100,000) (100,000&//(100,000) (100,000) 0 200,000 200,000 200,000 . . . 200,000 J l J l I I f I I I to tl t2 t3 0 o 0 t8 13For example see D. R. Gant, "Illusion in Lease Financing," Harvard Business Review, XXXVII (March-April, 1959), 121-152; and also R. F. Vancil, "Lease or Borrowe- New Method of Analysis," Harvard Business Review, XXXIX (September-October, 1961), 122-136. 1H9 The first step in one approach to analyzing leases is to calculate the total present worth of the series of lease payments. This procedure will allow a determination of the equivalentamount which would be needed to purchase the asset at time zero. Since leasing is in essence a form of borrowing, the discount rate should be a pure debt rate and is usually based on the firm's cost of long- term debt on an after-tax basis. The total present worth of the lease payments amounts to $701,969 when a 3% discount rate is used. This amount is called the "purchase equivalent" necessary to acquire the use of the asSet. The next step involves calculation of hypothetical annual income tax outlays. This calculation can be derived by viewing the present worth of each of the yearly lease pay- ments as "depreciation equivalents“ which would prevent the outflow of taxes each year. Annual cash benefits after deducting lease payments and taxes at a h8% rate would amount to $52,000. When the "depreciation equivalents" are added back the annual "cash flows" which would result are as shown on the time scale below. "Cash flows" = "Depreciation . equivalents" "Purchase equivalent" + Cash benefits after lease payments (701,969) 1h9,087 iu6,260 1fi§,514 . . . 130,9h1 ' I, 7]. ’1 fi’l II to t1 t2 t3 0 o o 0 t8 150 These cash flows are now comparable to the purchase equivalent just as any normal net cash benefits are comparable to the actual investment in a project when the internal yield is calculated. The discount rate which will equate the cash flow pattern shown on the preceding time scale with the purchase equivalent is slightly less than 12%. This rate is directly comparable with the pure equity yield on other investment projects. Calculations are shown in Appendix B for Illustration IV-H. An alternative approach to evaluating lease projects is briefly outlined below. Assume the firm in the preced- ing example has an Option to purchase the asset outright for $6h0,000 rather than leasing. From an opportunity cost viewpoint, the savings which would result from purchasing the asset would be the annual $100,000 lease payments. However, the firm would also gain annual depreciation allowances which would amount to $80,000 yearly on a straight- line basis. The incremental earnings or net cash benefits after taxes resulting from purchasing rather than leasing would thus amount to $90,H00 annually. The rate which discounts the net cash benefits back to $690,000 is slightly over 2.7%, and is calculated in Appendix B. This rate can be viewed as the incremental yield or return from purchasing instead of leasing. Conversely, it can be said that the opportunity cost of leasing rather than purchasing is 2.7% after taxes. Since it was assumed earlier that the long- term debt financing rate is 3%, the leasing arrangement from 151 a cost basis is slightly more advantageous than borrowing and subsequently purchasing the asset outright. [Still another alternative to measure the attractive- ness of leasing or buying is the total wealth concept. Assuming funds are available to purchase the asset in question, the alternative use of these funds until the lease payments are made annually is a very relevant factor. A decision to lease should then be made if the total funds can be utilized on various shorter-term investments in such a way that a greater total wealth can be accumulated than would occur if the asset is purchased. Tying up funds by an outright purchase often precludes the use of funds for a number of relatively smaller but more profitable projects. Of course, the assumption that short-term profitable projects will continually arise is crucial and may not be warranted. ,Leasing previously offered several advantages from a tax standpoint. Three of these are discussed briefly below. (1) Lease payments could be deducted on a more rapid basis than depreciation on purchased assets. (2) Land was essentially depreciated in certain cases while it could not be so treated if it was bought outright. (3) Both debt and equity financing costs were tax deductible. Since the advent of accelerated depreciation measures in the 195% Code the amortization of a purchased asset can be just as rapid as write-offs for lease payments, and is 152 often more rapid. These depreciation provisions have at least partially eliminated the first advantage mentioned above. When the lessee expenses the entire lease payment as it is incurred, land is effectively amortized if its cost is part of the total rental requirement. Thus, this advantage still exists to a substantial degree and may be important for certain kinds of lease arrangements. Finally, to the extent that additional debt finan- cing can result from lease arrangements without impairing equity costs, the ability to write off the total financial charges related to the lease is still advantageous. One of the principal tax disadvantages in many lease arrangements is the inability of the lessee to gain the benefit of the investment credit which would otherwise be available on a purchased asset. However, the benefit is allowed to be directly passed on by some lessors when the transaction is in essence an instalment purchase. In addition, it may be indirectly passed on by other lessors through lower rental payments. One of the tax disadvantages from the viewpoint of proponents of leasing used to be the favorable capital gains treatment allowed if assets were purchased and subsequently sold. As implied on page 122 much of this advantage is being gradually eliminated by the depreciation recapture pro- visions and lease arrangements will no longer be discriminated against by this factor. 153 Leasing and Income Taxes--Practice Although outlays for leases are not usually included in the published figures for annual capital expenditures, lease projects are subjected to essentially the same evaluation procedures as other capital outlays in thirty-eight of the firms visited (Table 9-3). In many instances, the tools of analysis utilized for lease pro- posals are more SOphisticated and rigorous than those that are applied to more frequently encountered purchase type proposals. In a few firms, discounting techniques that were first utilized for leasing proposals have subsequently spread to use for other types of decisions. The amount of actual leasing entered into by the firms in the study varies substantially, but in over three- fourths of them it is not important in terms of other capital outlays. The most typical situation where leasing arrangements have been advantageous have been automobile fleets, computers and data processing machines, and other facilities where high degrees of obsolescence weigh heavily [on the decision. Certain transportation companies also lease facilities to a great extent in relation to other outlays. Most of the executives interviewed stated they are often confronted with proposals to lease facilities, but usually reject them after careful scrutiny. The principal tax advantage of leasing that was mentioned in the firms visited was the ability to amortize 19+ the cost of using land as was discussed in the preceding section. Another reason offered in a few firms was that special leasing arrangements had been devised so that the effective after-tax financial costs were nearly zero. Finally, several executives stated that the provision allowing the investment credit to be—passed on to the lessee had resulted in a second look at leasing arrangements for some projects. Summary This has been the first of two chapters considering a number of tax factors that can influence the incremental investment and cash benefits of new capital projects. The theoretical emphasis on most of the factors discussed in this chapter have involved either a terminal cash flow at the end of a project's life, or an initial outlay which could result in immediate or subsequent tax effects on the cash flow pattern. The income tax influences are generally considered, although often incorrectly, by the majority of the firms for such factors as working capital flows, salvage values for both new and replaced assets, gains on assets sold, and the alternative use values of replaced assets. The principal reasons given by firms for ignoring these factors were a lack of relevancy and the inability to predict the amounts involved for specific proposals for more than a few years in the future. 155 Questions were asked in the field interviews in regard to what items other than plant and equipment are generally evaluated as capital expenditures. Research and development costs, major acquisitions, major mainte- nance or repairs, and interest and carrying charges are not evaluated as capital expenditures by a majority of the firms. The theoretical issues regarding the proper treat- ment and analysis of these items are slightly cloudy at best, and the practices of the firms seemed to corroborate the cloudiness. Leased facilities are considered to be capital eXpenditures by nearly 90% of the firms even though the annual amounts involved seldom approach the size of other outlays such as research or major maintenance. The substantial amount of technical literature pertaining to analyses of leasing decisions appears to have had an important impact on most of the firms in the study. The principal advantages, taxation or otherwise, are quickly discerned and if they outweigh the advantages from purchased assets the lease proposal may be accepted. If not, the proposal is usually summarily rejected. The next chapter includes an analysis of the effective tax rate used by firms, inflation and other kinds of risk, and other more general factors which influence the cash flows related to Specific capital projects. CHAPTER V BROADER ISSUES: EFFECTIVE TAX RATES, RISK, AND INFLATION This chapter concludes the examination begun in Chapter IV of tax factors that can influence the cash flow patterns of individual capital projects. However, the illustrations and theoretical discussions in Chapter IV and other earlier chapters were purposely simplified in many instances. Cash flow projections were usually assumed to remain at a constant level from year to year. Individual capital-expenditure projects were analyzed largely in isolation from the rest of the firm. Various elements of risk and uncertainty were ignored in most discussions. The extremely important topic of the influences of inflation on capital investment analysis was skirted entirely. Income tax rates were usually assumed to be equal to the existing h8% statutory levy. It is appropriate that the final major chapter of this study considers these broader topics, and their interrelationships with topics in earlier chapters and with each other. The practices found in the field study, and their respective rationales, are again set forth and briefly analyzed. Table 5-1 presents a summary of the findings of practices involving some of the tax provisions that influence the effective tax rate imposed on business 156 157 firms. Table 5-2 indicates the practices found regarding various treatments of risk in the investment decision- making process. Effective Income Tax Rates Some measure of profitability is the basis for nearly all newly proposed capital projects of U. 3. business firms. The profitability measures may be implicit or A explicit depending on the type of investment decisions- involved. The absolute profitability on all projects is reduced by the imposition of Federal income taxes. The higher the effective tax rate the greater the reduction in the absolute incentive to invest in new projects. Further— more, the tax is not neutral in its impact on the decision- making process, and the relative position of individual projects is often altered by the size of the tax rate. The risks involved in different kinds of projects can also be substantially altered by the size of the tax rate. Some of the factors that influence the size of the effective tax rate are examined in the following pages. The first section considers the influence of operating loss provisions. Operating Loss Deductions Firm operating losses result from ordinary operating income being lower for a tax year than allowable deductions for operating expenses. Deductions generally result either from outlays made during the current tax year or from the 158 amortization of the initial cost or other tax basis of long-term assets in use. Although most of the following discussion relates to the latter deduction, the principles apply equally as well to current year eXpense outlays by taxable entities. The concept of a tax saving resulting from amortiz- ing the cost of long-term assets was discussed in Chapter ‘ III, and can be extended to an examination of various kinds of tax losses discussed in this chapter. E. Cary Brown has presented much of what is pertinent for this discussion. Brown concerned himself with the lack of neutrality of a proportional business income tax on the incentive to invest in different types of capital projects. His discussions were placed in the context of the present worth of the tax saving resulting from depreciation allowances for the initial cost of assets. His principal conclusions are stated briefly below.1 (1) The effect on investment incentives of a pro- portional tax levied on business income can be neutralized (a) if the amount invested can be ’deducted from taxable income in the year it is made, and (b) if the Government will pay for any losses of the firm at the same rate as it taxes the firm's income. Neither adjustment taken alone is sufficient to neutralize the effects of the tax imposition. (2) Depreciation of assets over a short period, such as three to five years, would come reasonably lE. Cary Brown, "Business-Income Taxation and Investment Incentives," Income “m 10 ;ent and Public Policxg Essays in Honor q§_Alvin H. ' ork: J. . orton.a 0., Inc., l9HS), Chapter IV. (3) (h) (5) 159 close to neutralizing the adverse effect of the tax, provided the excess of depreciation or other costs over income in any year can be carried forward as an offset against future taxable income. If depreciation for tax purposes is spread over the economic life of an asset, the tax will adversely affect investment incentives, even though the Government reimburses business operating losses at the rate of tax. Under such a system of economic-life depreciation incentives to invest are more adversely affected Za) the longer-lived the asset in which the investment is contemplated, (b) the higher the cost of investment funds to the individual firm, and (c) the greater the uncertainty of future income. These latter two effects are particularly severe on the new or small firm. Incentives for replacement proposals are less affected than incentives to make new investment. The existing firm would have its advantages furthered as against the new firm, because replace- ment outlays would be a larger proportion of total investment for the former than for the latter. For similar reasons, the static firm is favored over the growing one. The effects as indicated in points (2) and (H) are greater, the higher the rate of Federal income tax. In regard to point (1) above, the present worth of the tax savings from depreciation allowances grows as it is shifted forward toward the time of asset acquisition. However, the relative pre-tax position of investment projects will not be restored unless the present worth of the depreci- ation tax savings offsets the decrease in income due to the imposition of the income tax. This neutralization can occur only if the asset is fully amortized in the year of acquisi- tion. A first-year write-off is a necessary condition for complete neutralization, but it is not a sufficient condition. 160 If taxable receipts for a business entity are less than annual deductible expenses the Government would need to reimburse the firm for any such losses at the same rate as revenues are taxed to insure complete neutralization for all projects. The influences of accelerated depreciation indicated in Brown's conclusions were discussed in Chapter III, and need no further consideration here except as they affect operating loss provisions. Section 172 of the Internal Revenue Code provides for the deduction from taxable income in other years of net Operating losses resulting in the 2 Net Operating losses of corporations can be current year. carried back and offset against gross income for the three previous tax years. Refunds of some or all of the taxes paid in those years are possible. If a corporation's operating loss deduction is not used up by the carryback provision, the remaining portion may be carried forward for as many as five years and deducted from gross income. If the deduction is not exhausted within the succeeding five years its benefit is lost to a corporation. If provisions such as Code Section 172 were not available, the effective tax rate would be higher over a period of years for firms experiencing operating losses and fluctuating profits than for firms having a stable income 2For a detailed discussion of Code Section 172, see 1955 Federal Tax Course (New York: Commerce Clearing House, Inc., 1963), pp. 1603-1616. 161 stream. Some discrimination does exist in favor of utility and other industries experiencing relatively steady demand for services, but only from the carryforward provision. The present worth of the future decrease in taxes resulting from the loss carryforward is naturally less than an immediate tax rebate that has been suggested by Brown. Annual losses should also be examined in relation to specific capital-expenditure projects. The ability to pool income and deductible expenses that are related to all assets utilized by a business entity enables losses incurred on certain projects to be offset against profits from others. Taxes on income from profitable capital outlays can thus be reduced by early losses that may result from new projects as they are being brought on stream. In the evaluation process of new projects a hypothetical rebate should be added to the annual cash benefits for each year a loss is expected. This procedure can certainly enhance the economic desirability of some projects relative to others, and especially in situations where long start-up times or trial runs are necessary before a normal revenue pattern is generated. As shown in Table 5-1, only eight of the firms visited in the field study have actually eXperienced tax operating losses in the past ten years. These firms have generally attempted to recognize the absence of an income tax liability in new project analyses since it could certainly influence 162 TABLE 5—1 EFFECTIVE TAX RATE FACTORS IN PROPOSAL EVALUATIONS Factors Firms Operating Losses Experienced in Recent Years: Parent corporation 8 Subsidiaries or divisions 30 Individual Proposal Losses Properly Considered 28 Abandonment Losses Considered Important 3 Section 1231 and Capital Losses Considered Important lO Statutory Tax Rate Utilized 29 State Income Taxes Considered Properly 2H the final accept-or-reject decisions. Three of these firms have utilized straight-line depreciation for tax purposes in attempting to minimize the current period's tax loss, and to defer the amounts to be deductible until revenues are generated in future periods. These firms have lost some tax deductions for allowable amounts of depreciation due to long periods of tax losses and the five-year carryforward limita- tion. It should also be stressed that these firms indicated that straight-line depreciation does not generally result in a large enough annual charge to calculate properly net profits or losses from an accounting viewpoint. Thus, not only are these firms being discriminated against by not being allowed an immediate rebate for operating losses, but their tax losses and published financial statements are both 163 being misstated by using the straight-line procedure rather than more accelerated methods of depreciation. One other important element of discrimination involving the operating loss deduction allowed in the Code should be mentioned. It was stated in Chapter III that the annual allowable investment credit is generally restricted to $25,000 plus 25% of a firm's tax liability exceeding the $25,000 level. Credits in excess of this limitation may be carried back three years and forward five years with certain restrictions. Most of the comments in the preceding para- graphs regarding discrimination are again relevant, since a firm cannot receive the benefits from the credit provisions unless a tax liability exists. The credits may thus be lost forever due to a low and/or cyclical earnings pattern.3 While it may be argued that an inefficient firm should not be promoted by the tax laws, this view is a value judgment and it can be just as effectively argued that incentive measures should not be discriminatory, and may be just what such firms need to help pull them out of their financial doldrums. Slightly more than one-third of the companies inter- viewed do not properly recognize the influence on the total 3A firm does not have to be operating at a tax loss to be discriminated against by the investment credit provisions in the Code. Firms that are expanding rapidly, but are not yet earning large profits must also frequently use the credit carry back and carry forward provisions since low tax liabilities are being coupled with relatively large investment credits. 16% tax liability that results from some projects generating losses while others generate profits (Table 5-1). Three principal arguments were given for this practice. (1) The accounting system is not sufficiently refined to generate enough information about most individual projects to make such distinctions generally feasible. (2) There is no rational basis for making any such distinctions between projects. (3) Each project should be made to "stand on its own merits and not depend on tax gimmicks to justify its acceptance.“ While the first reason may be a practical reality in some firms, the latter two are theoretically weak and should not be allowed to prevent a correct project evaluation where the desired information is generated by a firm's accounting system. Abgndonment and Retirement Losses on Business Property If income taxes were not imposed on the profits of business firms the size of the undepreciated value of an old asset would have no influence on the decision to replace or discard it. Discussions in Chapter IV have shown how salvage values in general can influence investment decisions when the old asset is sold or traded in, but losses that may result from disposition were not elaborated on. When the usefulness of an asset held by a business firm is suddenly terminated an abnormal retirement loss is allowable as a deduction. If the asset is physically abandoned the entire adjusted basis is deductible as a loss. If an asset is retired, but is not disposed of, a deductible 165 loss is recognized under Regulation 1.167 to the extent that its adjusted basis exceeds salvage or fair market value if the retirement: (1) is abnormal, (2) is normal and carried in a separate asset account, or (3) is normal and carried in a multiple asset account and the tax depreciation is based on the life fif the longest lived asset in the account. This regulation generally has the effect of an immediate tax saving that should be related to the new asset being considered for acquisition if it is the new asset which in fact results in the disposition of the old one. The overall effective tax rates of business firms are thus altered, and another scrambling element in the capital-expenditure decision-making process results. The pre-tax rankings of investment projects are altered by the imposition of the income tax and the deductibility of these losses. Replace- ments of undepreciated assets move up the ranking ladder relative to replacements of fully depreciated assets, and probably more importantly relative to new expansion projects where replacements are not involved. Existing and static firms that have large amounts of replacement proposals relative to new and rapidly expanding firms will have an advantage over the latter due to the imposition of Federal income taxes and these loss provisions. 1+Ibid., pp. llhé-llHB. See the discussion of 166 Only three firms indicated abandonment or retire- ment losses are important with any degree of frequency. Two of these firms attempt to consider what influences abandonment would have on a new project's desirability if it occurred suddenly and prior to the end of its expected economic life. Approximately one-third of the firms visited do not consider the effects of the abandonment loss provision because it is seldom involved in replacement proposal evaluations. This reason is not surprising in view of the fact that nearly all of the firms in the study write off fixed assets using accelerated depreciation methods for tax purposes. The undepreciated tax basis is normally rather small unless a project has to be abandoned quite soon after acquisition. Irrespective of the lack of frequency of occurrence however, these loss provisions should not be ignored where they can substantially influence the ultimate investment decision. One other reason firms probably do not consider Regulation 1.167 as being important relates to the accept- ance criteria utilized for replacement decisions. As was mentioned in Chapter II, many small replacement projects are accepted after only a minimal (if any) effort is made to lapply mathematical acceptance criteria. Since only the time-adjusting acceptance criteria can show the correct impact of these provisions, and replacement proposals are seldom evaluated with such criteria in some firms, it is not surprising that the sensitivity of investment decisions to 167 abandonment losses is often not recognized by business firms. Section 1231 and Capital Losses The influence of capital gains on investment decisions was discussed briefly in Chapter IV. Both capital gains and capital losses influence the effective tax rate a firm ultimately pays. If a replaced asset is sold for less than its undepreciated tax basis, the result- ing loss may be a capital loss or treated as such if the transaction involves a Section 1231 asset. Capital losses are generally first offset against capital gains and thus prevent the tax outlays which would otherwise be necessary . for the gains. If the capital losses exceed capital gains a five year carryforward is available for corporations.5 However, most of the replacement decisions being made by firms usually involve Section 1931 assets which are merely treated as capital assets. Net 1231 gains are taxable at the maximum capital gains rate of 25%. If Section 1231 losses exceed Section 1231 gains, the net losses are deductible fully from operating income in the year incurred and are not carried forward. This treatment of Section 1231 losses results in discrimination against projects depending on when the asset is sold, and what gains are available to offset the loss. The tax saving that results from a deduction from normal Operating income is obviously 51bid., pp. 153u-1536. 168 worth more than a 25% capital gain tax saving. Less than one-fourth of the firms visited have experienced a substantial number of losses on capital assets and Section 1231 assets in recent years. Losses were usually more than offset by gains in these firms. The majority of the firms visited consider the influences of Section 1231 and capital losses explicitly in evalu- ating replacement proposals in the relatively small number of cases in which the accept-or-reject decisions could be influenced. Barent-Subsidiary Relationships The Internal Revenue Code contains many provisions that influence the effective tax rates paid by a parent corporation and its subsidiaries. Only three such provisions were examined in the field study: consolidated tax returns, subsidiary operating losses, and foreign tax credits. Consolidated Returns and Subsidiary Operating Losses. A group of affiliated corporations can file a consolidated ' tax return and be taxed as a single economic entity. Interfirm transactions must be eliminated to derive the single entity's net taxable income. Prior to the Revenue Act of 196%, a 2% penalty rate was added to the 22% surtax rate that was applied to consolidated net income. The penalty was offset to some degree by the allowance of an additional $25,000 tax exemption for each affiliate included 169 in the consolidated return. Both the 2% penalty and additional exemption provisions were eliminated by the Revenue Act of 196%. For most large firms, the advantage gained from the elimination of the former typically out- weighs the latter's deletion from the Code.6 Approximately one—half of the firms visited in the study were filing a consolidated return. Nearly one-fourth of the firms interviewed indicated that for the first time a consolidated return had recently been filed or was currently being seriously considered. However, the primary points of emphasis in this phase of the interviews were the absolute levels of the tax rates used for evaluation purposes and whether the same rates were used in evaluating both parent and subsidiary investment projects. Twenty-nine of the firms in the study that evaluate projects on an after-tax basis utilize the current Federal statutory rate (Table 5-1). Three firms use a 50% tax rate primarily for convenience in project calculations. Five firms use a rate that is considered to be an approximation of the effective tax rate actually incurred from parent and subsidiary operations. The effective tax rates obviously vary between these firms, and are estimated by considering 6Ibid., see pp. 1918—1920, for a discussion of Code Sections ISOl-lSOh. Ample evidence was given in Chapter III regarding the influence of a tax rate reduction on new investment. The penalty elimination and tax cuts combined amount to 6% for those firms that were previously filing consolidated returns. 170 many of the factors that are examined in this chapter. When either the parent firm or any subsidiaries incur a loss from Operations the tax saving concept is again relevant. For example, assume that one or more subsidiaries are expected to operate at a loss for a given future period. Since these losses can be offset against the operating profits of the parent corporation for Federal income tax purposes, the total tax paid will be less than the statutory rate multiplied times the parent's profits. It is therefore not logical to continue to deduct taxes in the cash flow estimates for projects being evaluated by or for subsidi- aries. Analytically, the net cash flows projected for the subsidiary's projects should be increased by h8% of the expected losses because they prevent an outflow for taxes.7 To do otherwise would result in discrimination in allocating capital to new and growing subsidiaries that often incur losses in the early years of operations. The present worth and recovery periods of investments in such subsidiaries are definitely enhanced by the ability to offset losses against other taxable income earned by the parent corpora- tion. Even if a consolidated return is not filed, the losses suffered on individual projects undertaken by subsidiaries should be recognized analytically in deciding between alter- 7The same principle applies to firms organized with operating divisions or groups, but consolidated returns are not involved. l7l native uses of funds. The ability to carry such losses back or forward was discussed in the first section of this chapter, and should be explicitly recognized in the manner discussed at that time. Thirty of the firms visited have subsidiaries that have Operated at a loss in recent years (Table 5-1). Six- teen of these firms do not explicitly recognize in the evaluations prepared for subsidiary capital projects the fact that no taxes may be expected to result from subsidiary operations. Three primary reasons were given for including an outlay for taxes in evaluating projects for subsidiaries that have operated at a loss. (1) Losses are not expected to persist for any appreciable period of time. (2) Losses are not generally predictable with any degree of accuracy. (3) Projects of the subsidiaries should be made "to stand on their own feet just as must parent capital projects." The first two reasons are not generally arguable. However, if losses are predictable to any degree and are expected to persist beyond a year or two, nothing can be gained by ignoring reality and blindly applying a rate for a tax liability against subsidiary projects when none will in fact result. Nearly all of the firms that make no such distinc- tion for varying tax rates have foreign subsidiaries that Operate at a loss. Due to the variability of foreign tax rates, it seems even more imperative that these firms explicitly recognize the possibility of discriminating 172 against subsidiary projects that would otherwise be economically desirable. Foreign Income. The complexities involving foreign income and taxes could easily fill several volumes of rather detailed discussions. Much has been said about certain loopholes in the Code that concern foreign income, and the attempts made by the Revenue Act of 1962 to close the lOOpholes. No attempt will be made in this study to survey all of the complexities involved in foreign income and the taxes related thereto. A credit for foreign taxes paid is allowed as a direct reduction of the U. S. tax liability of domestic corporations that hold a certain portion of the outstanding stock of foreign firms.8 The credit is allowed upon receipt of dividends from the foreign subsidiaries. A credit is also available for taxes paid by foreign "con- trolled" corporations even though the earnings have not been distributed to the U. S. parent corporation.9 The primary points of investigation in the field study were whether the parent firms receive dividends from foreign subsidiaries, 8Ibid., see pp. 2HO3-2hl?, especially regarding Code Section 901. Corporations also have the option to deduct the taxes paid from gross income. 91b1d., see pp. 2u17-2h19, for a discussion of "controlled" corporations and Code Section 951-958. 173 and what tax rates are applied in the economic evalua- tions for subsidiary capital projects. Approximately three—fourths of the firms interviewed have foreign subsidiaries from which dividends have been received in recent years. Most of these firms have also had foreign subsidiaries that have operated at a loss. As noted in the preceding section, many of these firms still apply a tax rate to the projects being evaluated for the loss subsidiaries. Several other firms apply what is felt will be the effective tax rate for the particular sub- sidiary and country involved. The total rate may be higher than the U. S. rate, and depends on the country in which the subsidiaries are located. Ten firms even attempt to recognize the influence that delays expected in repatriation of dividends will have on a subsidiary's cash flow estimates for particular projects. This approach is definitely correct and highly desirable where possible. State Income Taxes The last factor to be discussed that involves effec- tive tax rates is the relevancy of state income taxes. Thirtyeseven states currently have corporate income taxes with maximum rates ranging as high as 10”. The economic desirability of a project may thus be influenced substanti- ally depending on the state or states in which it generates revenues. Without becoming embroiled in the complexities of a variety of state income tax laws, it can be generally 17H concluded that some addition should be made to the Federal income taxes imposed on capital projects that are also exposed to state income tax levies. Whether all of the details of individual state tax laws should be considered in evaluating projects is probably open to question on the grounds of expediency. The area of what income should in fact be taxed in given states is still a very Open and disputed question. Some explicit consideration should nevertheless be given for state income tax levies when capital investment projects are being evaluated. Twenty-eight firms earn income in states that have corporate income tax laws. Thirteen of these firms include the state income taxes in cash flow estimates as an additional expense entirely separate from Federal income taxes. This approach is certainly valid, and it highlights in the evaluation process the differences in taxes imposed in the various states. Four firms ignore state taxes based on the grounds of irrelevancy. Several other firms add the state income tax rate directly to the Federal rate. State income taxes were acknowledged as having important influences on certain projects in a few of the firms visited. Risk and Income Taxes Risk is such a multifarious concept that no attempt will be made in this thesis to examine it comprehensively. Nevertheless, no study of the influence of Federal income tax factors on capital eXpenditure decisions would be 175 complete without some consideration of the tOpic of risk. The remaining pages in this chapter include a brief look at certain sources of risk. The concept of time risk as it is related to different kinds of capital projects is examined. Several of the more useful methods that are used for analyzing and highlighting the influences of risk on the decision-making process are briefly discussed. The final section of the chapter considers a type of risk that influences all of the discussion in this thesis--the risk of inflation or rising costs and prices. Sources of Risk Merrett and Sykes have presented a discussion of the following sources of risk that are related to the capital investment decision-making process.10 Risk from undertaking_insufficient numbers of similar projects. This risk exists when business firms consider only a small number of projects of a similar nature, and arises even if completely accurate estimates of the probabilities associated with different project variables are possible. The risk still exists that the mean profit from a given type of project will not materialize due to the possible failure of the law of averages Operating with so few similar investments. Risk from misinterpretation of projected data. This risk results from the human element of mis- interpretation and faulty forecasting of interrelated factors that are involved in investment decisions. Risk from bias in the data and its assessment. Both the derivation and assessment of the raw data for capital projects are subject to the risk of bias loSee Merrett and Sykes, Chapter 6. Much of the discussion in the rest of this chapter is a condensation of some of the material presented by these authors, but with a particular emphasis on income tax factors. 176 on the part of the individuals involved in the decision-making process. In addition, numerous biases result from the income tax laws. Some of these biases have been discussed throughout this thesis. It is important that the decision-maker knows that certain biases exist before he can be unbiased. Risk from a changinggeconomic environment. The past data usually utilized to assist firms in projecting the future will not often remain unchanged. Changes involving varying market shares, prices, government tax policies, general economic conditions, etc., are all important but often are not controllable by individual firms. Incorrect decisions can result from a failure to consider the possible influences of such external changes on the decision-making process. Risk of analytical errors. Both the technical and financial analyses of capital projects are subject to error. Nearly all project analyses will have some errors of this type, and consequently the risk of a faulty decision being made is present. Much of the discussion in previous chapters was related to the possibility of erroneous financial analyses through the use of certain accept- ance criteria. Furthermore, both the inclusion and exclusion of most of the tax factors discussed may result in faulty analyses. The possibility of exclusion was discussed thoroughly, but equally serious errors may also result if tax factors are included but are either improperly included or the results are erroneously interpreted. The sources of risk discussed briefly above are not necessarily mutually exclusive in their impact on investment decisions. Furthermore, they are related in many instances to the element of time risk which is examined below. Frequently the longer the time period related to an invest- ment project, the greater the risk of error from data bias, predictability of environmental changes, misinterpretation of projections, and analytical errors. 177 The Time Risk Factor The element of time risk relates to the possibility of sudden and complete cessation of the cash benefits being generated by capital projects. The general importance of how soon a firm could expect to break even from a new investment has been discussed throughout this thesis. In addition to the traditional recovery period approach, a so-called progressive recovery period concept was outlined in Chapter II. A substantial portion of the discussion of the tax factors that have been examined in this study has ,been related to their influences on a project's recovery period. Indeed, the element of time risk is the major type of risk that most tax provisions have been intended to influence. Provisions such as accelerated amortization, the depreciation guidelines, the investment credit, and immediate write-offs of research and development costs have all been related mainly to a more rapid recovery of the investment in a new and possibly risky project. A distinction between the time risk concept and other sources of risk is an important one in the evaluation process. Recovery period measures, and the influences on them of the above mentioned tax factors, are related entirely to the time risk element. These measures do not generally highlight sources of risk other than the time factor. Many of the firms visited either have not recog- nized, or often do not explicitly consider, this important 178 distinction. When the question was posed: "Do you consider risk eXplicitly in the decision-making process, and if so, how?", the answer in approximately half of the firms was, "through using a shorter recovery period requirement." The other firms in the study indicated the methods of analysis discussed in the next section were used to consider risk elements--both of a time nature and other- wise. ’ One further point should be made concerning the time risk factor and the break-even or recovery period. The rate of recovery is probably at least as important as the absolute magnitude of the time period involved. For example, it is important to know that an investment will be 80% recovered in three years when the total payback period is six years. Twenty-one of the firms using recovery period calculations also consider the rate of recovery eXplicitly in project evaluations. Approaches to Probability Analysis Nearly all of the firms visited in the study utilize some form of probability analysis in evaluating new projects. However, most firms consider probabilities only indirectly or implicitly. The individuals involved in the decision- making process usually include their estimates of the figures that have the greatest likelihood of occurrence. These estimates are Obviously based on subjective judgment. One of the difficulties that is involved in this approach is 179 that the most likely value that is expected can have any probability as long as it is of a higher magnitude than the next most likely figure. Another problem is that the most probable values can vary widely between different types of projects, or even the same type of projects over differing periods of time. Different probabilities for many tax factors can substantially influence investment decisions. To illustrate, consider an asset that costs $10,000 and has an estimated useful life of five years. Further assume a salvage value estimate of $2,000 is included in the evaluation process, and that the expected probability of this amount is 0.5. If the next most likely estimate is that salvage value may be -$500, and the probability is 0.h5, then a lack of eXplicit consideration of the latter possibility might easily result in an erroneous decision when the project is compared with others having different risks and probabilities. Another approach to probability analysis that is commonly discussed, but is much less frequently used, involves the calculation of the mean or average expected monetary value (EMV) for each quantifiable variable. Con- sider the example below involving salvage values. The most probable salvage estimate is $5,000, and is denoted Event S2. The expected probability for 82 is 0.6. The other two salvage estimates are $10,000 and zero, and each has an expected probability of 0.2. The average expected monetary value equals the most likely estimate of $5,000 in this case, 180 (l) x (2) (1) (2) (3) Event Probability Amount EMV 51 0.2 $10,000 $2,000 82 0.6 5,000 3,000 83 0.2 zero zero 1.0 5,000 but only because both the probabilities of the individual events and the expected amounts of salvage values were assumed to be symmetrical. If 31 and S3 had probabilities of 0.1 and 0.3 respectively, the expected monetary value would amount to 3%,000. This difference in the "expected" salvage value could easily change the investment decision in this case.11 Errors in this type of analysis may also arise from weighting the probabilities of each event according to their relative arithmetic size when the proba- bility of the probabilities may be substantially dissimilar. If the 0.3 probability of event S3 in the second case above had been "forced" due to a lack of knowledge about the estimate, it should obviously not be given the same weight as the probabilities of SI and 82 if the latter are completely certain at 0.1 and 0.6 respectively. Executives in three of the firms stated that an attempt to weight explicitly the probabilities of various 11This discussion ignores differences in the marginal utility of money. The implicit assumption in the example above is that the marginal utility is constant irrespective of the dollar amounts involved. 181 events is made in analyzing some capital-expenditure prOposals (Table 5-2). In several other firms it was mentioned that a rough average of the most likely estimates (e.g., two or three values) is used for many variables. TABLE 5—2 APPROACHES TO<30NSIDERING RISK IN PROPOSAL EVALUATIONS I 1* Approaches Firms Probability of Expected Monetary Values 3 Sensitivity Analysis 3% Simulation by Models M Variable Cut-Off Requirements 30 Calculation of Specific Price-Level Changes 2% Calculation of General Price-Level Changes 3 Sensitivity Analysis Approximately three-fourths of the firms interviewed utilize some form of sensitivity analysis in evaluating new proposals (Table 5-2). Sensitivity analysis involves changing the magnitude of certain crucial variables to ascertain what influences on the economic desirability of projects can be expected. An illustration of sensitivity analysis is as follows. Assume that a 10% price reduction is being con- sidered for a one-year period until a firm's product can gain a certain share of an existing market. Even though 182 the desired share of the market can be obtained, assume the price reduction will make the product line operate at a loss for the first year. As was noted in an earlier section of this chapter, the ability to offset the loss on one project against profits on others for Federal income tax purposes may make the proposal acceptable. To test the sensitivity of the proposal to price changes, an alternative assumption may be that a 25% price reduction should be considered. Although early losses would be greater, the larger price reduction may result in a gaining of the desired market share more rapidly. Both the size and time value of the losses resulting from the hypothesized price reductions can have an important influence on the proposal. All of the factors involving taxation which have been discussed in previous chapters can be analyzed, varied, and further analyzed. Such variables as salvage values, depreciable tax lives, immediate writeoffs or capitaliza- tions, levels of expected tax rates, debt/equity ratios and levels of expected after-tax capital costs, and many others can be changed to determine how importantly different project's desirabilities depend on them. One particularly crucial problem that arises in most sensitivity analyses is the inability of the decision-maker to vary more than one or a few variables at the same time. Frequently the interaction of variables cannot be easily ferreted out. This problem has been alleviated somewhat by a few firms through the use of model building and simulation techniques. 183 Simulating Risk Mathematical model building and simulating risk have grown in importance in many areas of decision-making in recent years. Barish has defined risk as:12 . . . the result of the variations in the values of a variable which are caused by the actions and interaction of many factors. He has also stated that simulation means:l3 . . . the use of a model which takes account of those essentials of reality which are significant to the decision-making objective. A decision is reached by running various alternatives through the model and comparing results. The model does not have to look like reality, but it must give the results which reality will give with respect to the problems under study. High-speed computers have been refined and develOped in recent years to the point where simulating risk may be a very economical way to analyze certain types of capital projects. The interactions of a variety of assumptions that involve many different variables can be derived and evaluated through the use of computer simulations. For example, if subjective probability estimates and ranges of values can be supplied for each factor involved in a capital- expenditure proposal, a simulation of the resulting range of internal yields or other acceptance measures is possible. By considering the probabilities and interactions of the 12Norman N. Barish, Economic Analysis for Engineering and Managerial Decision-Making (New York: McGrawefiill BoOk Company, Inc., 1962), p. 393. 131bid., p. 380. 18% variables involved, computers will produce estimates of the probability of reaching a given internal yield, i.e., the probability of achieving a yield of 1H% is 95% or higher. Four of the firms interviewed have used computer simulation techniques to analyze a few very large and important investment projects. However, none of these firms were any more concerned with tax factors than any other crucial variables. Although the multitude of possible Ivalues and probabilities for the tax factors discussed in previous chapters could undoubtedly be handled through computer simulations, the size of such an undertaking is beyond the scope of this study.lh Cut-Off Requirements Another approach utilized for handling risk in the decision-making process is to vary the size of the cut-off requirements for acceptance of projects involving different types and levels of risk. After the internal yields, recovery periods, or other criteria are calculated most firms still must allocate capital between projects. The question raised in the interviewing process was whether cut-off or target requirements were used, and if so, whether they were 1l+For illustrations of simulation applications to capital budgeting in general, see Leon W. woOdfield, "An Experiment in Application of The Monte Carlo Method for Simulating Capital Budgeting Decisions under Uncertainty" (unpublished D.B.A. thesis, Department of Accounting and Financial Administration, Michigan State University, 1965). 185 calculated on an after-tax basis. Several firms had an absolute minimum cut-off rate of return, and nearly half of the firms had minimum recovery periods. Executives in thirty firms indicated their cut-Off requirements would vary to some extent, and would depend on the risk and nature of the projects involved (Table 5-2). Accordingly, a proposal for the replacement of a machine which will have little salvage value and for which the expected cost savings are quite predictable, would need to result in a much lower after-tax yield than a plant to be built for the production of a new and untested product. Executives in a total of thirty-eight firms indicated that target or cut-off requirements are used in the decision-making process. Ample evidence has been presented in this thesis to show that if cut-off yardsticks are to be compared with the acceptance criteria utilized they both must be on an after- tax hasis.15 All of the firms that calculate their acceptance criteria on after-tax basis are consistent in their comparisons with cut-off criteria. The Risk of Inflation The discussion thus far in this thesis has ignored the possibility of anticipated inflation and its influences 15For further elaboration regarding the need to use an after-tax cost of capital rate in proposal evaluations see, A. A. Robichek and J. G. McDonald, The Cost of Capital Concept: Potential Use and Misuse," Financial Executive, XXIV (June, 1965), 20-k9. 186 on the investment decision-making process. Inflation is a special kind of risk--the risk of rising prices and costs in both the economy in general and in individual firms. At least two kinds of adjustments may be necessary to properly calculate the yield on investment projects if inflation is expected to occur. First, if specific price or cost changes are expected, they should be explicitly reflected in the actual cash flow projections for individual projects. Twenty-four of the firms visited explicitly recognize specific price level changes in project evalua- tions. The primary reasons given by firms for not following this practice were that price changes are unpredictable, and are generally immaterial anyhow. However, several of the latter firms have in fact experienced price depressions for some of their products in recent years. Some of these firms have also experienced increasing wage and other costs. When these two factors are combined with even slight increases in the general price level, the real yields on projects may be altered substantially. Some eXplicit efforts should certainly be made to recognize the interaction of these factors in new project evaluations. A second important adjustment in project evaluations is necessary for the rate of general inflation that is anticipated so that the future dollar receipts may be equated in real present worth terms with the initial investment. From an analytical standpoint, the adjustment need not be nearly as difficult as is often thought. The adjustment for I. 187 both the time value of money and anticipated general inflation can be made at the same time by merely discounting the expected receipts by the factor yielded by R (1 + k)£(l + i)t discount rate in the absence of inflation, (i) is the rate when (k) represents the cost of capital or of general inflation expected, and (R) the dollar receipts anticipated in year (t). Illustration V—l Assume an investment of $1,000 at to is expected to result in a cash inflow of $1,%00 at t3 as shown on the time scale below. Further assume that the cost of capital in the absence of inflation is 7%, and the rate of anticipated general inflation is 3%. (1,000) 1,u00 / / t0 t3 The discount rate based on the preceding assumptions is exactly 10.21%. By using the present worth factor for 10% however, the real present worth of the expected benefit is approximated as $1,052. Calculations are shown in Appendix B. If annual receipts rise more slowly than the general price level, the real yield on the total capital invested will be less than the yield in the absence of inflation. If receipts are fully responsive to the general rate of inflation, the yield on total capital will remain unchanged. 188 However, these conclusions are based on several rather rigid and unrealistic assumptions. They apply only in the absence of income taxes, and when the project involves a non-depreciable asset that is financed entirely by equity funds. As has been shown in previous chapters, if a firm utilizes debt capital to partially finance invest- ment projects, this fact should be recognized explicitly in the evaluation process. Recognition is particularly important when income taxes are imposed and inflation exists. George Terborgh has succinctly analyzed some of the influences of anticipated inflation on capital invest- ment decisions. Two of his conclusions are stated below.16 The rationale for the conclusions of Terborgh are briefly explored in the rest of this section. (1) For a depreciable investment which is financed entirely by equity funds, inflation will reduce the real after-tax yield even if pre-tax receipts are fully responsive to the expected rate of general inflation. (2) For a depreciable asset financed by both long- term debt and equity, inflation will reduce the yield on total capital even though pre-tax receipts are fully responsive to inflation. The effect on the yield on equity capital depends on a number of factors such as the debt/equity ratio, the cost of debt, the rate of inflation, the tax depreciation procedures and asset service lives,salvage values, and the level of the statutory tax rate. In regard to the first conclusion stated above, the main factor influencing the yield on equity capital is the 16George Terborgh, Effect of Anticipated Inflation on Investment Anal sis (washington, D. C.: Machinery and AIIIe 3 Products InstItute, 1960), pp. 8-lh. 189 amount and pattern of depreciation of the cost of the asset. Since the monetary amounts of depreciation are restricted to total historical cost, the tax deductions for this factor do not move in response to general inflation as is often the case for wages, materials, and other costs. The real effective tax rate is therefore higher than it would be if depreciation were calculated on a price-level adjusted basis. The equity yield could remain constant in real terms under these assumptions if the pre-tax revenues were more than responsive to the general level of inflation. Alternatively, if the after-tax revenues can be increased by certain tax provisions the erosion of the equity yield can be prevented. The incentive provisions discussed in Chapter III--the investment credit, the tax rate reductions, the guideline system, and accelerated depreciation--can all enhance or at least prevent a deterioration of the real equity yield on capital projects. The results on project yields become substantially more scrambled when long-term debt funds are included in the analysis. When pre-tax revenues move in harmony with the general price level, the real return to total capital will decline as stated above in the all-equity case as a result of the fixed depreciation write-off. However, it is generally recognized that when inflation occurs the use of debt can enhance the return to equity capital. This is especially true due to the tax deductible nature of interest payments for the use of debt funds. Before complete 190 restoration can occur, the favorable influence of the use Of fixed cost funds on the equity yield must offset the unfavorable influence of historical cost depreciation. Terborgh has concluded that restoration will not generally occur, even with fully responsive receipts, unless the percentage of debt utilized equals the statutory tax rate levied on income.17 Under the current h8% corporate tax rate in the United States, a debt/equity ratio of nearly 1:1 would be required before the equity shareholders could break-even in terms of pre-inflation conditions. Two other factors involving tax influences that should be mentioned in a discussion of the impact of inflation on new proposals are asset salvage values and inventory valuations. Previous discussions have shown what influences salvage values and various related tax gain or loss provisions can have on investment decisions. To the extent that the size of an.asset's salvage value does not respond to the general level of inflation, further mitigat- ing effects can be expected on its real equity yield. When a portion of the initial investment in a project is for inventories, the equity yield under the mixed capital assumption may be enhanced by inflation. Enhancement will generally occur only when the proportion of debt financing is relatively high, pre-tax receipts are fully responsive, and the Last-in First-out method of l7Ihid., p. 13. 191 inventory valuation is utilized. The use of First-in First-out procedures normally results in a higher effec- tive rate in a period of general inflation, and the additional burden generally falls on the equity share- holder.18 Three of the firms visited make explicit efforts to adjust cash flow estimates for general inflation for projects being considered for some foreign subsidiaries. These subsidiaries operate in countries that have experi- enced rather high rates of general inflation in recent years. Nearly all of the other firms in the study normally apply higher recovery period or internal yield requirements, or attempt other indirect means, to consider the influence of inflation on capital investment decisions. NOne of the executives interviewed stated that their firms attempt to consider explicitly general inflation influences on new investment projects related to operations in the United States. Summary This chapter has included a brief examination of certain factors that influence effective tax rates, various types and approaches to analyzing risk, and the impact of inflation on capital-expenditure decisions. These broader issues cut across the entire decision-making process for new lBIbido , pp. 8-100 192 project proposals. Some of the subtle influences on specific proposal evaluations are either not recognized or are frequently ignored by many of the business firms in the study. The executives in many of the firms interviewed stated that the loss provisions discussed in the preceding pages are not usually explicitly considered in the evalu- ation of individual proposals. The principal reasons given in these firms were a general lack of relevancy due to the size of the losses incurred annually and a basic disagree-' ment with the assertion that such distinctions should be made in regards to specific capital-expenditure prOposals. Certain kinds of risk are considered in approximately three-fourths of the firms through utilizing sensitivity analysis for critical parameters. Variable cut-off requirements are used in two-thirds of the firms to consider risk in the decision-making process. Specific price and cost changes are considered in slightly over one-half of the firms, but general inflation is seldom considered explicitly in evaluating individual proposals. The conclusions of this study and certain tax policy implications are set forth in the next chapter. CHAPTER VI CONCLUSIONS AND TAX POLICY CONSIDERATIONS A recent study by Richard E. Slitor includes estimations of the tax savings that are expected to result from some of the tax incentive provisions that were dis- 1 Slitor estimates that the total cussed in Chapter III. savings during 1966 for the corporate sector will amount to over $6. billion from the tax rate reduction, the investment credit provision, and the guideline system. The rate reduction is expected to provide at least half of the $6. billion estimated savings, and the remainder is divided relatively evenly between the guideline system and the investment credit provision. This total tax savings certainly cannot be viewed as inconsequential when it is compared with the $61.6 billion projection for capital outlays during 1966 that was revealed in the recent McGraw- 2 Hill survey. Additional indirect investment incentives 1Richard E. Slitor, "The Corporate Tax Cut: What Business Did with the 'Windfall,'" Challenge, XIV (March- April, 1966), 26-28, 38, MO. 2The most recent survey is summarized in the article, "Full Steam for Spending," Business week, NO. 1911 (April 16, 1966), pp. 37-390 193 19% can be expected during the coming year from the multiplier effects of the tax savings, and more importantly, from the multiplier effects caused by the individual income tax rate reductions in the consumer sector. The conclusions in the next section must be examined with these and other factors as a frame of reference. General Conclusions The following general conclusions were derived primarily from the field interviews that formed the basis for the research for this thesis. (1) The vast majority of the executives in the firms that were visited stated that only nominal incentive effects have occurred in terms of the economic desirability of Specific capital prOjects. (2) The general supply of funds effects from the investment credit, theguideline system, and the corporate tax rate reduction were generally described as moderate in most Of the firms visited in the study. These moderate funds effects at least partially corroborate the unshifting results for tax rate reductions discussed in the Musgrave study that was mentioned in Chapter III. (3) The actions of the firms in the study, and the corporate sector of the economy in 195 general, that have been reflected in the tremendous surge in plant and equipment outlays in the past few years contradict* the first two findings stated above. The size and rates of increase for such outlays imply that the actual stimulus from the incentive measures has been somewhat stronger than was acknowledged in the field interviews. This possibility suggests even greater corroboration of the Musgrave thesis than was noted in the preceding conclusion. The following reasons appear to have had important influences on the first two conclusions of this study. First, deSpite some widely heralded improvements in the "business investment climate," substantial uncertainties seemed to exist in the minds of many of the interviewees as to future congressional or administrative tax policy changes. These uncertainties may play an important role in the lack of recognition of the incentive effects that can result from certain tax provisions. Second, although a distinct shift toward the use of the more sensitive time-adjusting acceptance criteria for project evaluations was found in many of the firms visited, the crudity of the measures in other firms has precluded an explicit recognition of incentive effects. This factor has been reinforced by the selectivity and restrictiveness of some of the provisions, most notably the investment credit. 196 Third, the greater speed up in tax payments for large corporations has had a definite dampening influence on the recognition of the incentive effects in some of the firms visited in the field study. Fourth, many of the firms were in a strong or excess liquidity position when the tax incentive measures began to take effect. This fact seemed to dampen somewhat the enthusiasm of the financial executives during the dis- cussions about the incentive measures. Fifth, some of the firms in the study were just beginning to be forced into greater reliance on external funds at the time of the interviews. The restrictive influences of the greater inelasticity of the supply of funds that have been suggested by Meyer and Glauber could not have been expected to change the viewpoint of firms toward the incentive measures until this increased emphasis on external financing began occurring. Finally, the selectivity and gradualness of the tax measures has undoubtedly contributed to the lack of explicit recognition of their possible incentive effects. Tax Policy Considerations The business investment climate has changed in several ways during the year that has elapsed since the field inter- views for this study were started. Interest rates for long-term debt have risen sharply since early in the second 197 quarter of 1965. The monetary authorities have taken several steps of a restrictive nature during this period, and the liquidity positions of many corporations have tightened somewhat. Graduated withholding of individual income taxes which became effective May 1, 1966, is expected to have at least a slightly dampening effect on business investment outlays. The substantially increased possibility of more rapid general inflation in the U. 3. economy due to the Vietnam military conflict and other factors has been widely discussed by economic prognosti- cators. Although the latest McGraw-Hill survey has shown that the capital outlay intentions of most business firms still point sharply upward, they appear to have been moderately scaled down more recently.3 This scaling down seems to have been partially because of the Administration's "moral persuasion? policy, and also has resulted from order backlogs, price increases, and supply shortages in the capital equipment and construction areas. Comments by public officials about the possibilities of tax increases and a moratorium on the investment credit have undoubtedly heightened the degree of uncertainty in the business community as to the ultimate overall profitability that can be expected from new fixed investment. The preceding comments suggest the possibility that the funds provided by the tax incentive measures, which are generally considered 3Ibid., pp. 37-38. 198 to be internal in nature, may currently be valued more highly than they were at the time of the field study. This possibility and the other findings of this study suggest the following conclusions regarding possible tax policy changes for the immediate future and in the long run. First, the investment credit provision should not be discontinued unless the likelihood of general inflation increases substantially in the next several months. To discontinue the credit even temporarily could cut substantially into projected levels for investment outlays when plant capacities are already being heavily strained. A moratorium would probably undermine still further the business community's uncertainty in regard to "that tax gimmick." This increased uncertainty could definitely dampen future incentive influences even if the credit is subsequently restored. Such a result would be an ineffi- cient allocation of national resources. Second, as the possibility of inflation fades and the general economy moves toward an economic downturn, the following policies should be considered by the Administration to more firmly entrench the investment credit as an incentive measure in the U. S. business community. (1) The 25% restriction on the annual allowable investment credit and the related carryforward provision should be eliminated. (2) The provision should be broadened to include assets other than those defined under Code 199 Section 38 to eliminate discrimination against certain kinds of capital projects. (3) The absolute size of the credit should be increased. These recommendations probably could not be implemented all at the same time because of Federal budgetary constraints, but they would overcome most of the uncertainty and criticism surrounding the investment credit provision that was found in the field study if implemented gradually over a period of time. Third, substantial modification or elimination of the reserve-ratio test should be considered after the probability of general inflation has subsided. This action would remove the primary reservation of the business executives in the study toward the true incentive nature of the guideline system. Again, the expectational effects as to when and how the reserve-ratio test might be implemented have probably caused much of the lack of enthusiasm found in many firms for the guidelines as an important incentive. Fourth, the corporate tax rate should not be increased even temporarily if such a policy can be avoided. A substantial amount of inertia and skepticism surrounded the expectations regarding the likelihood of the recent rate reduction and of its ultimate incentive influences. To restore the rates to the levels that had long been con- sidered oppressive, and from which relief had been given up in many quarters, could quickly result in greater 200 uncertainties and lackadaisical attitudes of business executives toward incentive considerations in the invest- ment decision-making process. Finally, the Operating loss carryforward provision should be made unlimited to prevent discrimination against certain firms and the distortion that may result on their published financial statements that was mentioned in Chapter V. Such a policy change would at least be a step in the direction of immediate tax rebates for operating losses that have been suggested in economic literature for quite some time. In summary, the speeding-up process for corporate tax payments and graduated withholding for individuals should be given a chance toaffect investment outlays, and the lagged effects of higher interest rates and other restrictive monetary policies should be given the oppor- tunity to become Operative before further policy changes are attempted. Restrictive fiscal policy changes should be considered with great caution lest the attempts of the past five years to cultivate a favorable investment climate be destroyed in a few short months because of temporary inflationary tendencies in the economy. Hasty action would undoubtedly give the business community additional reason for ignoring "those tax gimmicks." A Ih APPENDIX A MATHEMATICAL FRAMEWORK The following symbols provide the basis for the mathematical framework utilized in this study. k represents the effective interest rate determined by discrete end-of-year compounding or discounting. This rate may represent the cost of capital of a firm or the internal yield on a project depending on the context in which it is used. represents the time period or number of years involved in proposal evaluations. designates a present sum of money. This sum usually represents the cost of an asset at the beginning of the initial period. represents a single receipt or a series of receipts for (t) years. ’ designates a future sum or amount of wealth resulting from one or more receipts compounded to the end of some year (t) at interest rate (k). The equations for the basic mathematical framework for this study are presented on the next several pages. These equations are based on the symbols listed above and are stated frequently in both mnemonic and algebraic form. 201 202 As the illustrations in Appendix B indicate, the mnemonic factors named in the following captions describe the process that takes place in making the actual calculations.1 The alternative equations given and denoted (a) can be found in the literature of financial mathematics. Single-Payment Compound-Amount Factor (1) w = P(SPCA-k%-t) = P(l + k)t (l-a) Equation (l-a) is frequently described as "the amount of one" in the literature of financial mathematics. Single-Payment Present-WOrth Factor 2 P = w s wek -t = w 1 2- ( ) ( PP z ) ( (l + k)t ) ( a) Equation (2-a) is described as "the present value of one" in financial mathematics literature. Sinking-Fund Deposit Factor 1 > (3) R = W(SFD-k%-t) = w((1 + k), _ 1 (3-a) Equation (3-a) is often referred to as "the uniform series that amounts to one" in the literature of financial mathematics. lFor elaboration about the derivations and proofs of the equations presented for the basic framework in this thesis, see Norman N. Barish, Economic Analysis for Engineering and Managerial Decision-Making (New York: McGraw- Hill BoOk Company, Inc., 1962), pp. 49-60; and George A. Taylor, Managerial and Engineering Economy (Princeton, New Jersey: D. Van Nostrand Company, Inc., 196%), pp. 23-30. 203 Capital Recovery Factor k(l + k)t ) (1 + k)t - l (A) R = P(CR-k%-t) = P( (h-a) Equation (H-a) is often referred to as "the uniform series that one will purchase" in the literature of financial mathematics. Alternative formulations that are used later in Appendix B are given in Equations (5) and (5-a).2 _ _ k (5) R - P(SFD-k%-t) + Pk — P((l + k)£ _ 1) + Pk (5-a) Uniform-Series Compound-Amount Factor (6) w*= R(USCA -k%-t) = R((1 + kit ’ 1) (6-a) Equation (6-a) is frequently called "the compound amount of one per period" in financial mathematics literature. Uniform-Series Present-WOrth Factor t (7) P = R(USPW4k%-t) = R(k%l++kk)t- 1) (7-a) Equation (7-a) is often mentioned in financial literature as "the present value of an annuity of one." The first seven equations in this appendix are expanded and modified in the following pages to provide the complete mathematical framework that is utilized in this thesis. 2For a derivation of this alternative formulation, see Eugene L. Grant and W. Grant Ireson, Principles of En ineerin Econom , Nth ed. (New York: The Ronald Press Company, 15555, p. ”5. 20% Net Present WOrth Measure Equation (7) is restated below for the purpose of calculating the net present worth of an investment proposal that is expected to generate an even flow of net cash benefits after an initial outlay is made at time zero. In Equation (8) the cost of a proposal is denoted by (P), the expected net cash benefits by (R), and the discount rate by (k) for a given time period (t). (8) NPW = R(USPW-k%-t) - P Traditional Recovery Period Measure Equation (9) indicates how the traditional recovery period can be measured when the annual net cash benefits (R) are expected to be uniform, and only the initial invest- ment (P) is required to be recouped. = P (9) RP “fif Tax SavinggConcept The following symbols are utilized in many of the remaining equations in this appendix to show the influences of certain income tax considerations. G represents gross cash benefits expected annually from capital projects. 0 designates the expected annual amounts for cash disbursements for Operating expenses related to (G). Y represents taxable income expected to be earned each year. 205 r designates the tax rate charged annually against (Y). D indicates the annual depreciation allowable for tax purposes. represents income taxes payable each year. R designates net cash benefits expected for a year or series of years. Equation (10) defines taxable income (Y) assuming depreci- ation is not a factor in the asset generating revenues. (10) Y=G-0 Federal income taxes (T) are determined annually by applying the taX'rate (r) to taxable income as shown in Equation (11). (11) T = r(Y) or T = r(G -0) Net cash benefits after taxes (R) can then be derived as shown in Equation (12). (l?) R = G - 0 - T or R = G - 0 - tG + t0 or R=(l-t)(G-O) However, when depreciation is taken into account in some of the examples in Appendix B, net cash benefits after taxes must be restated as follows in Equation (13). 206 (13) R = (l - t)(G - 0) + t(D) Sum-of-Years—Digits Depreciation Equation (1%) shows how to determine the amount of depreciation allowable by the SYD method for the first year of the tax life of an asset where (t) represents the tax life, (P) the initial investment cost, and (L) the expected salvage value. (1h) D1 = (FREE—Exp - L) The annual allowable depreciation charge based on the SYD method declines by a uniform amount each year. This decline is determined by the following formula. The annual (15) d = (———§————)(P - L) t(t + l) decline of (d) begins in year two with D1 as calculated in Equation (1%) serving as the initial base. The present worth of the cash flow pattern that will result from the declining arithmetic gradient discussed in the preceding paragraph can be derived through the use of Equation (16). The annual gradient decrease in cash benefits is represented by (g) and the first year cash flow is symbolized by (Q) as follows. (16) NPW = Q(USPw-k%-t) - g(GPW;k%-t) - P 207 Declining-Balance Depreciation The depreciation rate for any year (t) that is allowable under the declining-balance method is twice the straight-line rate or 2/n where (n) is the tax life of an asset. The rate 2/n is applied to the book value at the 'beginning of the year (t) in question. Equations (17) and (18) show these relationships where (Dt) is the amount of depreciation for a given year, (B) represents the book value of the asset, and (P) is the initial cost. (18) Bt P(l - 2/n)t General Inflation Discount Factor To consider the general rate of inflation in the discounting process the factor yielded by 1t (l + k) (1 + l)t can be multiplied times any expected receipts (R). In the formulation (1) represents the expected rate of inflation for years (t) and (k) designates the cost of capital or discount rate in the absence of inflation. This approach to discounting for inflation is illustrated in the body of the thesis and the calculations are shown in Appendix B. APPENDIX B MATHEMATICAL CALCULATIONS This appendix includes the most important basic calculations that are involved in the illustrations in the body of the thesis. Each illustration is restated and is keyed to the numbers utilized in the thesis. The equations in Appendix A are utilized to derive most of the calculations for the illustrations. Illustration II-l Assume a project requires an initial investment of $20,000 at time zero, that annual net cash benefits of $2,981 are expected for ten years, and that the cost of capital is estimated as 7%. Net Present WOrth Equation (8) is utilized below to derive the net present worth (NPW) of the project. (8) NPW = R(USPW-k%-t) - P NPW = $2,981(USPW—7%-10) - ($20,000 NPW = $2,98l(7.0236) - $20,000 NPW = (520,937 - $20,000 NPW = $937. 208 209 Internal Yield The internal yield is derived below for the project and is denoted by (k). The yield is approximated by linear interpolation as 8.0h%, but the exact yield based on Equation (8) is 8%. NPW = $2,981(USPW;9%-10) - $20,000 NPW = $2,981(6.%l8) - $20,000 NPW = $19,131 - $20,000 NPW = -$869. The NPW based on a 9% discount rate is negative, or -$869. The yield is approximated by interpolating as follows. k = g $?01937 - $20,000 _ z 7’ + ($909937 - $19,131) (9% 7') k = 7% + .52(2%) k = 8.0h% approximately Uniform Annual Charge The capital recovery variant of the UAC for Illustration II-l is derived below and is based on Equation (h). (k) R = P(CR-k%-t) R = 20,000(CR-7%-10) R = $20,000(.lh238) R = $2,8u8. Equation (5) was presented in Appendix A as an alternative formulation of Equation (h). The sinking fund variant of 210 the UAC approach can be calculated through the use of Equation (5). (5) R = P(SFD-k%-t) + Pk R = $20,000(SFD-7%—10) + $20,000(.07) R = $20,000(.07238) + s1,h00 R = sl,hh8 + sl,u00 R = $2,8u8. Illustration II-2 Figure 2-1 in the body of the thesis presents data for two proposals currently being considered by a firm. Proposal G requires a current investment outlay of $220,000 and has an expected life of ten years. Net cash benefits after taxes amount to $10,000 in t1 and are expected to increase each year by $10,000. PrOposal H requires an outlay of $220,000 and has the same expected economic life as Proposal G. Benefits predicted for t1 amount to $73,000, but are expected to decline each year by $8,000. Both assets have zero salvage estimates. A 50% income tax rate is anticipated for the ten-year period. Operating loss pro- visions are not assumed to be available for these proposals. The internal yields on Proposals G and H are approximately 15% and 16.8% respectively as shown on the following page. 211 Proposal G Equation (2) can be utilized to determine the internal yield on a prOposal that has uneven flows such as Proposal G. By applying the 15% factor to each year's net cash benefits that have been shown in Figure 2-1, a total present worth of $219,983 results. Interpolation results in an internal yield of slightly less than 15%. Proposal H Equation (2) can also be utilized to derive the internal yield for the uneven cash benefits pattern that is expected for Proposal H. By utilizing a discount rate of 15%, a total present worth for Proposal H of $230,535 results. By applying the single-payment present-worth factors for a 17% discount rate, a total wealth of $218,550 is found. By interpolating linearly between these two amounts as shown below, an internal yield of approximately 16.8% results. k = 1 g $2304535 - $220,000 . _ . 5' + ($230,535 - $218,sso)(17( 15%) kzl’ 10 ?. 5% + ($11,9 5)( %) k = 15% + (.879)(2%) k = 15% + 1.758% k = 16.758% 212 Illustration II-3 Assume the initial outlay expected for a new asset is $50,000 at time zero. Annual net cash benefits of $12,000 are expected for six years. A 10% cost of capital is assumed. Traditional Recovery Period By utilizing Equation (9) the traditional recovery period is shown to be h.17 years. :2. (9) RP R RP = $50,000 $12,000 RP = H.17 years Progressive Recovery Period The determination of a recovery period including a cost of capital charge (referred to as a progressive recovery period in the thesis) is facilitated by the use of Equation (H) which is restated below. (h) R = P(CR-k%-t) However, the number of years (t) is the unknown in this case rather than (R). The desired value of (t) can be found by calculating the capital recovery factor to multiply times the asset cost (P) to yield the known receipts (R). This calculation is shown on the following page. 213 $19,000 = $50,000(CR-10%-t) CR a $12,000 $50,000 CR = 0.2h000 In the 10% table prepared by Taylor, this value of CR falls between five and six years.1 Linear interpolation yields the following results. _ 0.26380 - 0.2H000 t _ + 1 r 5 years (0.26380 - 0.22961) ( yea ) t = 5 years + .7 years t = 5.7 years Internal Yield By interpolating between the present worths for 10% and 12%, a yield of approximately 11.5% is derived for Illustration II-3. 10% + ($52496“ -550,000) (12% - 10%) k: $52,?6N - 3N91337 k e 10% + (.773)(P%) k = 11.5h6% All of the calculations on the following pages will follow a format similar to the one used above. However, some of the intermediate steps are eliminated gradually for the sake of brevity. lTaylor, p. #50. All of the factors used in the calculations in this appendix are based on the tables prepared by this author. See pp. M39-h6l. 21h Illustration III-2 Assume the net cash benefits for a proposal that requires an initial investment of $10,000 are estimated to amount to $2,013 for a period of eight years. The internal yield (k) is exactly 12% as shown below, since the factor for this rate equates the expected benefits with the $10,000 initial outlay and results in an NPW of zero. Internal Yield Without Credit (8) NPW = R(USPW;k%-t) - P NPW = $2,013(USPW; 2%-8) - $10,000 NPW = $2,013(h.9676) - $10,000 NPW = $10,000 - $10,000 = 0 thus k = 12% Internal Yield With Credit An internal yield of 1H.2% is approximated below, and is based on the assumption of a 7% investment credit that is considered as a cash inflow at time zero. This assumption reduces the net initial investment to $9,300. The yield is derived by interpolating between the present worth of the cash benefits based on 12% and 15% discount rates, or $10,000 and $9,033 respectively. All subsequent yields will be approximated in a similar manner without additional elaboration. k = 12% + ($104000 - $9e300) (15% - 12%) $10,000 - $9,033 k = 12% + (.72%)(3%) k = 12% + 2.172% 1h.172% 215 Recovery Periods Without Investment Credit The traditional and progressive recovery periods are approximately 5.0 years and 7.5 years respectively without the investment credit. These periods are based on Equations (9) and (h) respectively as shown below. _ _g_ = $10,000 = (9) RP - R 3 2,013 h.967 years (A) R = P(CR-k%-t) or $2,013 = $20,000(CR-lO%-t) - 2 01 _ CR - 10,000 - 0.20130 thus 0.205% - 0.20130 0.205h1 - 0.187hh C,- II 7 years + ( )(1 year) 7 years +-.52 years d' cf u u 7.52 years Recoverngeriods‘With Investment Credit Following the same procedures as outlined above, the traditional and progressive recovery periods are roughly h.6 years and 6.5 years respectively. (9) RP : .3. = £24399. = H.62 years R $2,013 (A) R = P(CR-k%-t) or $2,013 = $9,300(CR - 10%-t) CR = $2191} = 0.216u5 $9,300 _ 0.22961 — 0.216h5 t " 6 years + (0.22961 - 0.203%1) (1 year) t = 6 years + .5h years t = 6.5% years 216 Illustration III-3 Assume the pre-tax cash flows for a project are expected to amount to $9,193. If these cash flows are reduced by a 52% income tax rate, the net cash benefits amount to $2,013. Assuming the same initial outlay of $10,000 and economic life of eight years as in the preceding illustration, the internal yield equals 12%. If the pre-tax flows are reduced by a h8% income tax rate, the after tax net cash benefits will amount to $2,180. Internal Yield With Tax Reduction An internal yield of 1H.H% results from interpolating between the present worth figures below for 12% and 15% rates respectively. . $10,829 - $10,000 4 y 12% + (£10,829 - $ 9,782)(15,9 - 12/0) 12% + (.792)(3%) = 12% + 2.376% l“-376% k Recovery Periods With Tax Reduction The traditional and progressive recovery periods are h.6 years and 6.5 years respectively, and the latter is based on a 10% cost of capital rate. = _E_. = .10 000 = . (9) RP R %_2TI80 h 59 years (A) R = P(CR-k%-t) or $2,180 = $10,000(CR-10%-t) CR = 2 180 = 0.2180 $10,000 6 years + (0.22961 - 0.21800 ) (1 year) (I... ll 6 years + .h8 years = 6.H8 years 217 Illustration III-h Assume that in 1961 a firm was considering the acquisition of an asset costing $1N,300 that was expected to provide estimated annual cash benefits of $1,820. Assume further the income tax rate was 52%. A zero salvage value estimate was expected, and straight-line depreciation was to be used for tax purposes. Internal Yield Without Guideline Depreciation An internal yield of 8.1% results from the following interpolation between the present worth figures for an 8% and 9% discount rate respectively. 8% + (filta385 -$1”13OO)(9% - 8%) k = $1h,385 _ $13,616 k = 8% + (.ll)(1%) = 8% + .11% k = 8.11% Recovery Periods Without Guideline Depreciation The recovery periods are 7.9 years and 11.8 years for the traditional and progressive measures respectively. The progressive measure is based on a cost of capital of 7%. : _2_ z 1% 00 = (9) RP R '%_If820 7.9 years (h) R P(CR-k%-t) or $1,820 = $19,300(CR-7%-t) - 1 820 - CR "$IET§06 — 0.12722 t 0.13336 - 0.12722 0.13336 - 0.12590 11 years + ( )(1 year) t = 11 years + .823 years = 11.823 years 218 Internal Yield With Guideline Depreciation An internal yield of 8.5% results on the project if it is assumed that the guideline procedures have just been made applicable and the tax life for the class to which the asset belongs has been shortened to eleven years. Cash benefits amount to $1,92H for the period and t t1 through tll’ and $1,2h8 for t 13' The interpo- l2 lation below is based on present worths for 8% and 9% respectively. 7 .1M 68 - 1M 00 . v k 8/0 + (WNW; ' 870 k 8% + (.52)(1%) = 8% + ,52% 8.52% k Internal Yield With All Incentives If the assumptions are made that the asset is eligible for the 7% investment credit and that the tax rate has been reduced to h8%, an internal yield of approximately 10.4% results as shown below. Cash benefits amount to $1,976 for the period t1 through tll and $1,352 for t12 and t13. The $1,001 investment credit is assumed to be a cash inflow at time zero and thus reduces the outflow at that time to $13,299. a $13,656 - $13,299 ,, _ g k 10% + ($13,656 - $12,025“1 7 10') k = 10% + (.22)(2%) = 10% + .22% k = 10.hh% 219 Recovery Periods kflth All Incentives The recovery periods are 6.7 years and 9.h years for the traditional and progressive measures respectively. The latter approach is based on a cost of capital of 7%. szi :1? :6. (9) R gfifggg 73 years (h) R = P(CR-k%-t) or $1,976 = $13,299(CR-7%-t) CR = $.11222. = 0.1h858 $13,299 : 0.153N9 - 0.1H858 t 9 years + (0.153R9 - 0.1h238)(1 year) t = 9 years + .Hh years = 9.%% years Illustration III-5 Assume a firm has $10,000 to invest in either of two capital-expenditure proposals. Proposal A will result in a net cash benefit at t10 of $30,600. Proposal B is expected to result in a net cash benefit at t5 Of $20,11H. An 8% cost of capital rate is assumed initially. Present WOrth Without Investment Credit By utilizing Equation (2) in Appendix A, the present worths of Proposal A and Proposal B are approximated below as $1k,l7h and $13,689 respectively. Proposal A (9) P = W(SPPW#k%-t) = $30,600(.%6319) : $1M,17h. Proposal B (2) P = W(SPPW-k%-t) = $20,llh(.68058) = $13,689. 220 IInternal Yield Without Investment Credit The internal yield is approximated below by inter- jpolating between 10% and 12% for Proposal A, and amounts 'to 11.8%. The yield on Proposal B is exactly 15%. Proposal A k = 108 3114798 ' $104900 12% - 10% + ($11,798 - $ 9,852) ( -) k = 10% + .92u(2%) k = 11.8k8% frotal.hkalth Without Investment Credit If the assumption is made that the $20,11h receipt expected from Proposal B at t5 can be reinvested at 9% ‘unti1.tlo, the total wealth accumulated at that time would amount to $30,987. The amount is derived below by using Equation (1) and letting the $20,1lh invested at t; represent (P) to accumulate to (W) in five years. Proposal B (1) W": P(SPCA-k%-t) w = $20,1lh(8PCA-9%-5) w = $20,1iu(1.5386) w = $30,9u7. The total wealth expected from PrOposal A is the cash receipt Of $30,600 at the end of year ten. Present WOrth Using Two Discount Rates The use of two cost of capital or discount rates is necessary for Proposal A to be comparable with PrOposal B 221 at to. A present worth of $19,888 is derived for Proposal A at t5 by discounting the $30,600 receipt at the assumed reinvestment rate of 9%. A present worth based on an 8% discount rate from t; back to to amounts to $13,535. Proposal A (2) P = W(SPPW-k%-t) = $30,600(SPPW-9%-5) thus P = $30,600(6h993) = $19,888 and a P = $19,888(SPPW;8%-5) = $19,888(.68058) P = $13,535- Total wealth With Investment Credit If a full 7% investment credit is considered to be available for Proposal A, the total wealth that can be accumulated at $10 amounts to $32,120. This amount is based on a $700 credit assumed to be reinvested at t1 at a 9% rate. Two credits of $233 are considered to be related to Proposal B and if reinvested at t1 and t6 at 9% result in a total wealth of $31,782 as shown below. Proposal A (1) w W P(SPCA-k%-t) = $700(SPCA-9%-9) = $700(2.l7l9) $1520. . The $32,120 total wealth estimate is derived by adding the amount that the investment will accumulate by tlo, or $1,520, to the $30,600 expected cash receipt at that time. 222 Proposal B (l) w = P(SPCA-k%-t) = $233(SPCA-9%-9) = $233(2.1719) W = $506. and (l) w = P(SPCA-k%-t) = $233(SPCA-9%-h) = $233(1.hll6) w = 8329. After adding the wealth accumulated from the two credits to the $30,9h7 calculated previously, the total wealth , that can be expected from Proposal B at t10 is $31,782. 1 Illustration III—6 Assume an asset costing $220,000 is expected to generate net cash benefits before taxes and depreciation of $62,000 for a ten-year period. No salvage value is expected at th and a #8% income tax rate is estimated for the period. The net cash benefits that will be generated after taxes for the SYD, DDB, and straight-line depreciation methods are shown below. Net Cash Benefits After-Tax YEAR SL syn DDB 1 $u2,800. $51,8u0. $53,360. 2 h2,800. $9,520. $9,136. 3 H2,800. $7,600. h5.757. A $2,800. $5,680. uu,053. 5 $2,800. h3,760. $0,891. 6 $2,800. $1,880. 39,161. 7 $2,800. 39,920. 39,161. 8 82,800. 38,000. 39,161. 9 $2,800. 36,080. 39,161. 10 h2,800. 3u,160. 39,159. Totals $h28,000 $828,000 $u28,000 223 The internal yield on the asset if straight-line depreciation is utilized is approximately 13.8% and is derived below. _ ( $281,829- $220,000 , k ’ 12% I ($2h1,829 — $205,813) (15% ' 12”) k = 12% + .606(3%) k = 13.82% rm If depreciation is calculated on the SYD basis, the first year writeoff will amount to $80,000 and is derived below through Equation (1%). This amount declines each year by $H,000 which in turn results in an annual increase in taxes of $1,920 based in the H8% rate. (1%) D1 = ETEEEIIT) ( P - L) D1 = (E%_§_%%)($220,000 - 0) D1 = 10/55 x $220,000 01 = $n0,000 The annual $H,000 decline in depreciation is calculated from Equation (15). (15) d = (——2———)(p .. L) t(t + 1) d = (_2_)($220,000 - 0) 110 d = 1/55 x $220,000 d = $8,000. Internal Yield The internal yield on the asset is roughly 15.7% based on the SYD method of depreciation. The NPW is derived on the next page based on a 15% discount rate. Interpolation 22% 'between the present worths for 15% and 17% results in the yield mentioned . (16) NPW = Q(USPW;k%-t) - g(GPW-k%-t) - P NPW = $51,HNO(USPW;15%-10) - $1,920(GPW;15%-10) - $220,000 NPW = $51,550(5.0188) - $1,920(16.979) - $220,000 ' NPW = $258,167 - $32,600 - $220,000 3 NPW = $258,167 - $252,600 f m = $5,567. *' 5% + ($225,567 _ $209,519) ( 7 5 ) k = 15% + .37(2%) k = 15.7% Total Wealth Measure By utilizing Equation (6) and assuming a 15% annual reinvestment rate, the total wealth that can be accumulated by th if straight-line depreciation is used amounts to $869,011. (6) w = R(USCA-k%-t) W’= $42,800(USCA-15%-10) = $82,800(20.30u) W'= $869,011 An accumulation of wealth amounting to $913,765 is possible if SYD depreciation is utilized. Each of the irregular cash flows resulting from this procedure can be compounded to tIO at 15% by using Equation (1). 225 Depreciation allowable for the first year of the asset's life under the declining-balance method amounts to $hh,000. Based on Equation (17) the amount is 2/10 of the book value at tO of $220,000. The depreciation charge decreases, and consequently the tax outlays increase, by a geometric gradient through t5. Since the tax authorities allow a switch to the straight-line method at the time it proves advantageous, the depreciation for the last five years amounts to $lh,%18 annually. The cash benefits pattern shown earlier for the DDB method result in an internal yield of approximately 15.3% as shown below. = - $22h,9h1 - $220,000 . _ y k 15% + ($22u,9ul - $209,169)(16% 15”) k = 15% + .3(1%) k = 15.3% Reinvestment of the tax savings resulting from DDB deprecia- tion for the asset being considered would accumulate to approximately $907,931 at t10° Once again, the compound amount factor derived from Equation (1) for each year would need to be applied to the uneven cash flows to determine the total wealth for the asset. Illustration IV-l Assume an asset costing $100,000 has an expected economic life of 20 years, but the guideline life for tax purposes is 10 years. Further assume a salvage value of $10,000 is anticipated at t20 and that a 12% cost of capital 226 rate is expected to exist for the firm in question. The income tax rate is assumed to be h8%. Equation (2) indicates the present worth of the $10,000 salvage value amounts to $1,037 at to. (2) P = W(SPPW;k%-t) P = $10,000(SPPW;12%-20) = $10,000(.10367) P = $1,037. If straight-line depreciation is used, the annual tax saving that would occur if the salvage value could be depreciated under Code Section 167 (f) amounts to $h80, or ($10,000/10)(.h8). The present worth of this stream of tax savings amounts to $2,712 as shown below utilizing Equation (7). (7) P = R(USPW;k%-t) P = $h80(USPWL12%-10) = $880(5.6502) P = $2,712. If SYD is the depreciation method used, the first year depreciation resulting from the $10,000 salvage value is 81,818. Based on Equation (15) the amount is derived by multiplying 2/21 times $10,000. The annual decline in depreciation can be derived by using Equation (15) and amounts to $182. The present worth of the tax savings resulting from the arithmetic gradient approach shown in Equation (16) is $3,162. If a 12% reinvestment rate is assumed, the total wealth that would accumulate at tgo based on Equation (1) being applied to each of the decreasing amounts of depreciation ;&"“" _ ”‘5 2?7 shown below will equal $30,511. This amount is in contrast to the $10,000 available from the expected salvage. SYD DEPR. $1,818. 1,636. 1,851+. 1,272. 1,090. 908. 726. sun. 362. 10 190. Salvage Depreciated $10,000. E5 :1> 2U \OmVOWIWAWJ 1:. ”7‘7“; Illustration IV-2 Assume a machine costing $100,000 was acquired on January 1, 1960, and was expected to prove useful and be depreciated over 10 years. Assume further that the double declining-balance method has been used to depreciate the asset for tax purposes and that it is sold for $70,000 on December 31, 1965. Based on Equations (17) and (18) the total amount of depreciation through 1965 is $73,786, and the post-1961 depreciation amounts to $37,786. The asset's adjusted basis is $26,218, or $100,000 minus $73,786. The recomputed basis is $68,000 as shown below. The total gain on the sale amounts £?6,?lh. Adjusted basis 37 686. Post-1961 depreciation $65,000. Recomputed basis to $83,786 ($70,000 - $26,918) and is divided between an 228 ordinary gain of $37,786 and a Section 1231 gain of $6,000 as calculated below. $68,000. Recomputed basis 26,218. Adjusted basis $37,786. Ordinary gain $83,786. Total gain 37,786. Ordinary gain $ 6,000. Section 1231 gain If the asset is sold for $85,000, the entire gain of $18,786 ($85,000 - $26,218) is taxable as ordinary income. Illustration IV-3 Assume a building costing $1,000,000 was acquired on January 1, 1962, and was sold for $850,000 on December 31, 1965. If the expected life was 20 years and DDB depreciation procedures were used, the adjusted basis on the date of sale should amount to $656,100 ($1,000,000 - $3h3,900). The accumulated depreciation is based on Equations (17) and (18). The total gain on the asset is $850,000 minus $656,100 or $193,900. Since the asset has been held 28 months beyond the 20-month provision under Code Section 1250, the total gain should be divided as follows. $103,608. Ordinary income (100% - 28% x $183,900) 90,292. Section 1231 gain (remainder) $193,900. Total gain The $183,900 represents the excess of DDB over straight-line depreciation ($383,900 - $200,000). If the 229 asset had been sold for $750,000, the total gain of $93,900 would have been divided as shown below. $67,608. Ordinary income (100% — 28% x $93,900) 26,292. Section 1231 gain (remainder) $93,900. Total gain Illustration IV-h Assume a project is being evaluated which would require lease payments at the end of each of eight years that amount to $100,000. The project is expected to earn $200,000 annually before considering the lease payments and income taxes. The present worth of the lease payments at a 3% discount rate amount to $701,969 based on Equation (7). This amount is termed the "purchase equivalent" for the asset services involved. By considering each year's outlay for the lease as a "depreciation equivalent" a cash flow pattern can be hypothesized. These depreciation equiva- lents are shown on the next page in present worth terms, and when added together they equal the purchase equivalent. Annual earnings after lease payments and taxes amount to $52,000 ($200,000 - $100,000 - $H8,000) if a tax rate of 88% is assumed. By adding the $52,000 annual earnings figure to each of the depreciation equivalents the hypothetical cash flow pattern can be derived. This hypothesized flow pattern is directly comparable with the purchase equivalent, and will result in an internal yield of slightly less than 12% based on Equation (2) being applied to each cash flow. 230 (1) (2) (3) (8) (5) (6) PW of Depr. Gross After-Tax Cash Year Rentals Equiv. Earnings Earnings Flows @ (to - (2) (3) + (5) 3% x (52%) 1 $100,000 $ 97,087 $ 200,000 $ 52,000 8 189,087 2 100,000 98,260 200,000 52,000 186,260 3 100,000 91,518 200,000 52,000 183,518 8 100,000 88,889 200,000 52,000 180,889 5 100,000 86,261 200,000 52,000 138,261 6 100,000 83,788 200,000 52,000 135,788 7 100,000 81,309 200,000 52,000 133,309 8 100,000 78,981 200,000 52,000 130,981 $800,000 $701,969 $1,600,000 $816,000 $1,117,969 If the firm has the alternative of purchasing the asset for $680,000 the annual depreciation allowances would be $80,000. ($100,000 - $80,000) would occur if the asset is purchased. Thus, a net "savings" of $20,000 annually Based on a 88% income tax rate the savings would amount to $10,800, and when added to the allowable depreciation a net cash benefit would result each year amounting to $90,800. The rate that equates this annual cash benefit pattern with the $680,000 outlay is approximately 2.7% as shown below. k k 2 $662,225 - $680,000 3 _ g z + ($662,225 - $638,582)(3f 2') 2% + .7<1%> 2.7% This rate can be viewed as the incremental yield from buying rather than leasing the asset. Lu.— 231 Illustration V-l Assume an investment of $1,000 at t is expected 0 to result in a cash inflow at t3 of $1,800. Further assume that the cost of capital in the absence of inflation is 7%, and the rate of anticipated general inflation is 3%. The actual rate to discount the $1,800 cash inflow is 10.21%, or (l.07)(l.03) - 1.000, and is based on the formulation in Appendix A. However, since tables are not usually prepared for fractions of a percent the discount factor for 10% is used as follows. "U H $1,800(.75131) $1,052. '"U II The $1,052 amount is the present worth of $1,800 expected at t3 and is discounted for a 3% annual inflation rate and by 7% for the time value of money. BIBLIOGRAPHY OF LITERATURE CITED Books and Monographs Barish, Norman N. Economic Analysis for Engineering and Managerial Decision-Making. New York: McGraw-Hill BoOk Company, Inc., 1962. Bierman, H. and Smidt, S. The Capital-Budgeting Decision. New York: The Macmillan Co., 1960. Brown, E. Cary. "Business-Income Taxation and Investment Incentives," Income, Employment and Public Policy, J Essays in Honor OfIAlvin H. Hansen. New York: W. w. Norton 8c Co., Inc., 1988. Butters, J. K., Lintner, J., and Cary, w. L. Effects of Taxation on Corporate Mergers. Boston: Division of Research, Graduate School of—Business Administration, Harvard University, 1951. . 1965 Federal Tax Course. New York: Commerce Clearing House, Inc., 1968. Grant, Eugene L. and Ireson, w. Grant. Principles of Engineering Economy. 8th ed. New York: The Ronald Press Company, 1968. Istvan, Donald F. Capital-Expenditure Decisions: How They Are Made in Large Corporations. Indiana Business Report No. 33. Bloomington, Indiana: Bureau of Business Regearch, Graduate School of Business, Indiana University, 19 l. Johnson, Robert W. Financial Management. 2d ed. Boston: Allyn and Bacon, Inc., 1962. Krzyzaniak, Marian and Musgrave, Richard A. The Shifting of the Corporation Income Tax. Baltimore: The Johns Hopkins Press, 1963. Merrett, A. J. and Sykes, A. The Finance and Analysis of Cagital Projects. New York:. John Wiley & Sons, Inc., 19 3. 232 233 Meyer, John R. and Glauber, Robert R. Investment Decisions, Economic Forecasting, and Public Policy. Boston: Division of Research, Graduate School of Business Administration, Harvard University, 1968. Porterfield, J. T. S. Investment Decisions and Capital Costs. Englewood Cliff : Prentice-Hall, Inc., 1965. Taylor, George A. Managerial and Engineering Economy. Priflceton, New Jersey: D. Van Nostrand Company, Inc., .196 . Terborgh, George. Business Investment Policy. washington, D.C.: Machinery and Allied Products Institute, 1958. ‘ . —~_—._ Al—‘V' .ML . Dynamic Equipment Policy. New York: McGraw-Hill Book Co., Inc., 1989. . Effect of Anticipated Inflation on Investment AnaI sis. washington, D.C.: Machinery and Allied Products Institute, 1960. 3:- . Incentive Value of the Investment CreditJ The Guideline Depreciation System, and the Corporate Rate Reduction. washington, D.C.: Machinery and Allied Products Institute and Council for Technological Advancement, 1968. Vassilatou-Thanopoulos, Elly. Financial Analysis Techniques for Equipment Replacement Decisions, Research Monograph No. 1. New York: National Association of Accountants, 1965. wyatt, Arthur R. A Critical Study of Accounting for Business Combinations, Accounting Research Study No. 5, New York: American Institute of Certified Public Accountants, 1963. Articles and Periodicals Bernhard, Richard H. "0n the Importance of Reinvestment Rates in Appraising Accelerated Depreciation Plans," Journal of Industrial Engineering, XIV (May-June, 1963). Davidson, Sidney and Drake, David F. "Capital Budgeting and the Best Tax Depreciation Method, Journal of Business, XXXIV (October, 1961). . "The 'Best' Tax Depreciation Method--l968," Journal of Business, XXXVII (July, 1968). 238 "Full Steam for Spending," Business Week, No. 1911 (April 16, 1966). ' Gant, D. R. "Illusion in Lease Financing," Harvard Business Review, XXXVII (March-April, 1959). Lorie, J. and Savage, L. J. "Three Problems in Capital Rationing," Journal of Business, XXVIII (October, 1955). "MAPI Study on Incentives," Journal of Taxation, XXIV (January, 1963). Raney, Lee C., Rist, Karsten A., and Wiebe, Henry A. "The Equivalent Annual Amount Method--A New Approach i to Investment Analysis," N.A.A. Bulletin--Management Accounting, XLVI. (April, 1965). Robichek, A. A. and McDonald, J. G. "The Cost of Capital Concept: Potential Use and Misuse," Financial Executive, XXIV (June, 1965). Slitor, Richard E. "The Corporate Tax Cut: What Business Digéwith the 'Windfa11,' Challenge, XIV (March-April, 19 Solomon, Ezra. "The Arithmetic of Capital Budgeting Decisions," Journal of Business, XXIX (April, 1956). "The Top 500 Industrials," Fortune, LXXII (July, 1965). Vancil, R. F. "Lease or Eorrow—-New Method of Analysis," Haggard Business Review, XXXIX (September-October, 9 ). Unpublished Material w00dfield, Leon w. "An Experiment in Application of The Monte Carlo Method for Simulating Capital Budgeting Decisions Under Uncertainty." Unpublished D.B.A. thesis. Department of Accounting and Financial Administration, Michigan State University, 1965. "11 lll'lilflillllllfllllfilis