Initial investment in capital budgeting decisions

Within context of capital budgeting decisions, initial investment refers to the cash outflow at the beginning of the project and is calculated by taking the total cost of the new asset (cost plus all expenses required to make asset operational), less after-tax proceeds from sale of the old assets and further adding or subtracting change in the net working capital, as shown below.

Initial investment (Initial cash outflow) determined as follows:

Total cost of the new asset (cost plus installation)

Less: After-tax proceeds from sale of the old asset (proceeds from sale of the old asset less cost of removing asset less tax on sale of the old assets.

Less or Add: Change in net working capital

Tax on the sale of the old asset is only paid if the asset sold for more than asset’s book value. Book value of an asset refers to the total cost of the asset (cost of the asset at the time it was purchased + installation cost) less accumulated depreciation.

Accumulated depreciation refers to the collective depreciation of an asset up to a point under consideration. For example, if asset were bought exactly 5 years ago, than accumulated depreciation will include sum of individual depreciation amounts for each of the five years.

If the asset sold for more than its book value than any value above original total cost of asset referred to as capital gain and any value above book value and up to original total cost of asset referred to as recaptured depreciation.

If asset is sold for less than book value than tax credit is generated, provided the country specific legal requirements for such tax credit to be effective are met.

As stated above, an initial investment is affected by the change in net working capital. This occurs because organization’s working capital requirements will change if project will be undertaken and it should be incorporated into calculations. A change in net working capital is calculated as change in current assets (e.g. accounts receivable and inventories) less change in current liabilities (e.g. accounts payable and accruals).

If net working capital increased (increase in current assets larger than increase in current liabilities) than we treat it as cash outflow and add it to the initial investment amount in calculation of the initial cash out flow. This is because the company’s investment in current assets increased due to the new project being undertaken. Therefore, it is an additional cash outflow.

If, however, an increase in current liabilities was higher than increase in current assets (if net working capital decreased) than we subtract this change in net working capital from the initial investment amount in calculating initial investment (outflow at time zero).

Commonly, there is an increase in net working capital (cash outflow) at the beginning of the project life. Such cash outflow is recovered at the end of the project when the terminal cash flow is calculated.

When determining cash flows we also need to consider opportunity and sunk costs.

Opportunity costs


Opportunity costs refer to the cash inflows that could have been earned in case of alternative employment of the asset. Therefore, it should be taken into consideration when determining cash flows.

For example, if success of the proposed project requires use of the equipment which organization already owns, the usage of equipment should be considered as a cost as if it would have to be bought or rented. Moreover, if such equipment could generate higher cash inflows in alternative use than this also should be incorporated.

Sunk costs


Sunk costs refer to the costs associated with the asset which is already was incurred in the past and cannot be recovered in spite of whether the particular project is undertaken or not.

An example of sunk costs is the feasibility study cost or marketing expenses which were already incurred for the project. In other words, any past costs that were incurred are not pertinent. Since sunk cost cannot be recovered – it should not affect decision regarding whether proposed project should be undertaken. In other words, sunk costs are not taken into account when cash flows for the potential project are calculated.

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An understanding of how the initial investment is calculated is an important first step in understanding how to properly make capital budgeting decisions. Make sure you gained a good understanding of concepts discussed above before moving on to further sub-sections on capital budgeting decisions.

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The debt ratio

A direct measure of debt of the firm is the debt ratio. Debt ratio measures how many of the firm’s assets are financed by debt. The higher the debt ratio the higher the degree of financial leverage (amount of debt) in the capital structure of the enterprise and the higher the risk and potential return.

The formula for the debt ratio is as follows:

Debt Ratio = Total liabilities/Total assets

If the debt ratio is higher than 1 than it means that an enterprise has more debt than assets. If the debt ratio is lower than 1 than it means that an enterprise has more assets than debt.

EXAMPLE:

Assume that ABC’s total liabilities are $1,700,000 and total assets are $4,000,000.

The debt ratio of ABC is as follows: $1,700,000/$4,000,000=42.5%

This means that ABC’s capital structure is 42.5% of debt and 57.5% of equity.

Test yourself


Dillon Corporation has total liabilities of $4,000,000 and total assets of $5,500,000.

Required: Find the debt ratio of Dillon Corporation

Solution:

The ratio is calculated as follows:

$4,000,000/$5,500,000 = 73%

This means that Dillon Corporation’s capital structure is 73% of debt and 27% of equity. A debt ratio of 73% is generally considered to be a very high debt ratio and may indicate a problem of a very high indebtedness and very high financial risk. However, as with all financial ratios, the debt ratio of Dillon Corporation should be compared to the industry average before any conclusions are drawn.

 

Total Asset Turnover

Total asset turnover is one of the activity ratios indicating the relationship between assets and sales (revenue). Activity ratios help businesses to measure how efficiently various accounts are converted into sales or cash. Other activity ratios include average payment period, average collection period and inventory turnover analysis.

It calculates how efficiently assets are used to produce sales or revenue. In other words, how efficiently the balance sheet is managed. It shows how many dollars of revenue is earned per each dollar of assets. It is also referred to as asset turnover or asset turnover ratio.

The formula to calculate the ratio is as follows:

= Sales(Revenue)/Total assets

The health of this ratio is an important factor which contributes to a healthy return on investment (ROI/ROA).

Example of total asset turnover ratio analysis


Assume Heroic Company has sales of $750,000 and total assets of $880,000. The total asset turnover of Heroic Company is calculated as follows:

$750,000 /$880,000=0.85 or 0.9

This indicates that Heroic Company turns over its assets 0.85 (0.9) times per year.

Things to note about total asset turnover ratio


Usually the higher the asset turnover number the more efficiently assets of the business are utilized.

Further, to obtain a better understanding, one should compare the ratio of individual firms to industry averages, to that of leading firms in the industry and to historical results.