Chapter 12
Capital Investment,
Leasing, and Taxation
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Chapter Outline
Capital Budgeting
Capital Investment
Financing Alternatives
Taxation
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Learning Outcomes
Identify the purpose of capital budgeting.
Compute business owners investment rates of return.
Identify advantages and disadvantages of capital
financing alternatives such as debt versus equity
financing and lease versus buy decisions.
Determine the effects of taxation on a hospitality
business.
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Capital Budgeting
In business, capital simply refers to money.
Those who invest their capital are, not surprisingly,
called capitalists, and the economic system that allows
for the private ownership of property is called
capitalism.
As is the case in most industries, investing money in
hospitality businesses can be risky.
Capital budgets are used to plan and evaluate
purchases of fixed assets such land, property, and
equipment.
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Capital Budgeting
Purchases of this type are called capital expenditures
and, as you learned previously, are recorded on a
businesss balance sheet.
Capital budgeting is the essential process by which
those in business evaluate which hospitality operations
will be started, which will be expanded, and which will
be closed.
In nearly all cases, business owners seek returns on
their investments which are large enough to justify the
continued investment of their capital.
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Capital Budgeting
In general, capital budgeting techniques can be
classified as those that are directed toward one or more
of the following business activities:
Establish a business (new venture, sometimes
funded by venture capitalists)
Expand a business (increase revenues)
Increase efficiency (reduce expenses)
Comply with the law (mandated change)
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Capital Investment
Investors seek to balance the concepts of risk, with that
of reward (increase vs. decrease in value).
In most cases, as the amount of risk involved in an
investment increases, the return on that investment also
increases.
As an investor you would ultimately seek to compare the
cost of making an investment today against the stream of
income that the investment will generate in the future.
To best make this in the future value comparison, or
time value of money, which is the concept that money has
different values at difference points in time.
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Time Value of Money
To illustrate the time value of money concept, assume
that you have won $10,000 in the state lottery. Your
options for collecting payment are:
Receive $10,000 now, or
Receive $10,000 in four years.
If you are like most people, you would choose to receive
the $10,000 now.
It makes little sense to defer (delay) a cash flow into the
future when you could have the exact same amount of
money now.
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Time Value of Money
From an investment perspective, those in business
know you can do much more with money if you have it
now because you can earn even more money through
wise investments.
The value of the money that is invested now at a given
rate of interest and grows over time is called the future
value of money. The process of money earning interest
and growing to a future value is called compounding.
See Go Figure! for an illustration of this.
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Time Value of Money
The effect of a compound investment earning 10%
annual returns is summarized below.
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Time Value of Money
When a future value is known, then the present value,
or the amount the future value of money is worth today,
can be determined.
The process of computing a present value is called
discounting, or calculating the value of future money
discounted to todays actual value.
See Go Figure! for an illustration of this.
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Time Value of Money
Future values and present values can be calculated
using the formulas stated in this chapter, time value of
money tables, and/or financial calculators.
As you (and all savvy investors) now recognize,
maximum returns on money invested (ROI) are
achieved by utilizing one or both of the following
investment strategies:
1. Increasing the length of time money is invested
2. Increasing the annual rate of return on the
investment
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Rates of Return
Before closely examining rates of return, it is very
important for those in the hospitality industry (as well as
all other industries!) to understand that operating profits
are not the same as return on investment.
Sometimes, a restaurant that achieves a very good
profit (net income) is still not a good investment for the
restaurants owner.
In other cases, a restaurant that achieves a less
spectacular net income is a better investment.
See Go Figure! for an illustration of this.
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Rates of Return
Actual returns on investment can vary greatly, but few, if any,
investors will for a long period of time invest in a restaurant if
the net income is less than what could be achieved in other
investment opportunities with the same or lesser risks.
Sophisticated managerial accountants can utilize several
variations of the basic ROI formula to help them make good
decisions about investing their capital.
For working managers interested in maximizing returns on
investment, two of the most important of these formula
variations are:
Savings Rate of Return
Payback Period
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Savings Rate of Return
The savings rate of return is the relationship between
the annual savings achieved by an investment and the
initial capital invested.
An example of this information based on Amy Sussums,
a country club manager who is contemplating the
purchase of a new dish machine, is presented in Figure
12.4 and the following Go Figure! exercise.
In many cases, managerial accountants and/or the
owners of a business will set an investment return
threshold (minimum rate of return) that must be
achieved prior to the approval of a capital expenditure.
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Payback Period
Payback period refers to the length of time it will take to
recover 100% of an amount invested.
Typically, the shorter the time period required to recover
all of the investment amount, the more desirable it is.
Managerial accountants often utilize the payback period
formula to evaluate different investment alternatives.
See Go Figure! for an illustration of this.
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Capitalization Rates
In most cases, business investors are not guaranteed a
return on their investments.
Investment returns typically increase as an investments
risk level increases.
To fully appreciate how business investors estimate
their ROIs and then consider risk levels, you must first
understand capitalization rates.
In the hospitality industry, capitalization (cap) rates are
utilized to compare the price of entering a business (the
investment) with the anticipated, but not guaranteed,
returns from that investment (net operating income).
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Capitalization Rates
This ties investment returns to:
The size of the profits (net operating income)
generated by the business
The size of the investment in the business
Net operating income (NOI), in general, is the income
before interest and taxes you would find on a restaurant
or hotel income statement.
Investors generally do not want to pay more than the
true value of any specific hospitality business or
property they are considering purchasing.
See Go Figure! for an illustration of this.
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Capitalization Rates
Cap rates that are higher tend to indicate a business is
creating very favorable net operating incomes relative to
the businesss value (selling price).
Cap rates that are lower indicate that the business is
generating a smaller level of net operating income
relative to the businesss estimated value (selling price).
In general, cap rates are used to indicate the rate of
return investors expect to achieve on a known level of
investment.
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Financing Alternatives
For investors, financing simply refers to the method of
securing (funding) the money needed to invest.
Theoretically, financing alternatives for a purchase could
range from paying cash for the full purchase price
(100% equity financing) to borrowing the full purchase
price (100% debt financing).
Because investments are typically financed with debt
and/or equity funds, the precise manner in which
financing is secured will have a major impact on the
return on investment (ROI) investors ultimately achieve.
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Debt versus Equity Financing
With debt financing, the investor borrows money and
must pay it back with interest within a certain timeframe.
With equity financing, investors raise money by selling a
portion of ownership in the company.
Common suppliers of debt financing include banks,
finance companies, credit unions, credit card
companies, and private corporations.
Equity financing typically means taking on investors and
being accountable to them.
ROI on equity funds is achieved only after those who
have supplied debt funding have earned their own
ROIs.
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Debt versus Equity Financing
Equity investors typically are entitled to a share of the
businesss profits as long as they hold, or maintain, their
investments.
The amount of ROI generated by an investment is
greatly affected by the ratio of debt to equity financing in
that investment.
The debt to equity ratio in an investment will also affect
the willingness of lenders to supply investment capital.
Figure 12.6 illustrates the affect on equity ROI of
funding the investment with varying levels of debt and
equity.
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Debt versus Equity Financing
For any investment, the greater the financial leverage or
funding supplied by debt, the greater the ROI achieved by
the investor.
Why not fund nearly 100% of every investment using
debt? The answer to this question lies in the column titled
Debt Coverage Ratio.
This is the same ratio as the Times Interest Earned ratio
that you learned about in Chapter 6.
The debt coverage ratio is a measure of how likely the
business is to actually have the funds necessary for loan
repayment.
See Go Figure! which illustrates how to calculate this.
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Debt versus Equity Financing
Lenders will analyze debt coverage ratios to determine the
risk they are willing to assume when lending to an
investors project.
Projects with lower than desirable debt coverage ratios will
most often come at a higher cost (interest rate).
Because of risk, some lenders will provide debt financing
for no more than 50 to 70% of a projects total cost. This
creates a loan to value (LTV) ratio, a ratio of the
outstanding debt on a property to the market value of that
property, of 50- 70%.
The projects owners, then, will have to secure the balance
of the projects cost in equity funding.
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Lease versus Buy Decisions
Leasing, (an agreement to lease) allows a business to
control and use land, buildings, or equipment without
buying them.
In a lease arrangement, lessors gain immediate income
while still maintaining ownership of their property.
Lessees enjoy limited property rights and distinct
financial and tax advantages, as well as the right, in
many cases, to buy the property at an agreed upon
price at the end of the leases term.
Figure 12.7 details some significant differences
between the rights of property owners (lessors) and
lessees of that same property.
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Lease versus Buy Decisions
The most significant financial difference between buying
and leasing is that payments for owned property by
lessors are not listed as a business expense on the
monthly income statement.
Rather, the value of the asset is depreciated over a
period of time appropriate for that specific asset on the
balance sheet.
Payments for most (but not all) leased property by
lessees, however, are considered an operating expense
and thus are listed on the income statement.
See Figure 12.8. for advantages of leasing.
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Lease versus Buy Decisions
Despite their varied advantages, leases can have distinct
disadvantages in some cases including:
Non-ownership of the leased item or property at the end
of the lease.
In situations where few lease options exist, the cost of
leasing may ultimately be higher than the cost of buying.
Changing technology may make leased equipment
obsolete, but the lease term is unexpired.
Significant penalties may be incurred if the lessee seeks
to terminate the lease before its original expiration date.
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Taxation
Managerial accountants who fully understand the very
complex tax laws under which their businesses operate
can help ensure that the taxes these businesses pay
are exactly the amount owed by the business, and no
more.
This is important because when the correct amount of
tax is paid, ROIs will be maximized and not wrongfully
reduced.
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Income Taxes
Taxing entities such as the federal, state, and local
governments generally assess taxes to businesses
based upon their own definitions of taxable income.
It is the job of the tax accountant to ensure that the
businesses they advise do not overpay on their taxes.
Tax avoidance is simply planning business transactions
in such a way as to minimize or eliminate taxes owed.
Tax evasion, on the other hand, is the act of reporting
inaccurate financial information or concealing financial
information in order to evade taxes by illegal means.
Tax avoidance is legal and ethical, while tax evasion is
not.
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Income Taxes
Taxable income is generally defined as gross income
adjusted for various deductions allowable by law.
There are about 2.1 million regular, or C corporations
in the United States.
The income tax rates (at the time of this books
publication) for C corporations are shown in Figure
12.9.
It is important to understand that all businesss net
income is taxed at the federal level, but it most often
also is taxed at the state and even local levels.
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Capital Gains Taxes
A capital gain is the surplus that results from the sale of
an asset over its original purchase price adjusted for
depreciation (asset basis).
A capital loss occurs when the price of the asset sold is
less than the original purchase price adjusted for
depreciation.
Capital gains and losses occur with the sale of real
assets, such as property, as well as financial assets,
such as stocks and bonds.
The federal government (and some states) imposes a
tax on gains from the sale of assets.
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Property Taxes
In addition to income and capital gains taxes, most
hospitality businesses will be responsible for paying
property taxes on the property owned by their
businesses.
These assessments are determined through a real
estate appraisal, which is an opinion of the value of a
property, usually its market value, performed by a
licensed appraiser.
Market value is the price at which an asset would trade
in a competitive setting.
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Other Hospitality Industry Taxes
Hospitality businesses are responsible for reporting and
paying a variety of hospitality industry taxes.
Sales Tax. In most cases, sales taxes are collected from
guests by hospitality businesses for taxes assessed on
the sale of food, beverages, rooms, and other
hospitality services. Typically, the funds collected are
then transferred (forwarded) to the appropriate taxing
authority on a monthly or quarterly basis.
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Other Hospitality Industry Taxes
Occupancy (Bed) Tax. Occupancy (bed) taxes are a
special assessment collected from guests and paid to a
local taxing authority based upon the amount of
revenue a hotel achieves when selling its guest rooms.
Tipped Employee Tax. Tipped employee taxes are
assessed on tips and gratuities given to employees by
guests or the business as taxable income for those
employees. As such, this income must be reported to
the IRS, and taxes, if due, must be paid on that income.
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Modified Accelerated Cost
Recovery System (MACRS)
Depreciation is a method of allocating the cost of a fixed
asset over the useful life of the asset.
Depreciation is subtracted on the income statement
primarily to lower income, thus lower taxes.
The portion of assets depreciated each year is
considered tax deductible because it is subtracted on
the income statement before taxes are calculated.
The Modified Accelerated Cost Recovery System
(MACRS) is the depreciation method required for
equipment in the hospitality industry (and all industries).
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Modified Accelerated Cost
Recovery System (MACRS)
MACRS was designed to accelerate depreciation in the
first years of depreciating an asset in order to reduce
the amount of taxes paid in those years.
This is especially good for new businesses whose net
income may be small in the first few years of
operations.
Depreciation for real estate, however, follows straightline depreciation, which is the cost of the asset divided
evenly over the life of the asset.
MACRS establishes shorter recovery periods than in
straight-line depreciation.
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Modified Accelerated Cost
Recovery System (MACRS)
MACRS calculations are based on property class lives
and an estimated salvage value (the estimated value of
an asset at the end of its useful life) of zero.
Property class lives as they are applied to hospitality
businesses are shown in Figure 12.11.
Depreciation using MACRS is calculated using stated
percentages for varying property classes (see Figure
12.12).
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Modified Accelerated Cost
Recovery System (MACRS)
The number of recovery years (years of depreciation for
the asset) include one more year than the years of the
property class life. This is because of the half-year
convention.
The half-year convention allows for one-half of a years
depreciation to be taken in the year of purchase and
one-half in the year following the end of the class life.
In effect, this allows for one more year of depreciation.
The salvage value is subtracted from the original cost of
the asset before depreciation is calculated.
See Go Figure! for an illustration of MACRS.
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Role of Hospitality Managers
While it is not reasonable for most hospitality managers
to become tax experts, it is possible for them to:
1. Be aware of the major entities responsible for tax
collection and enforcement.
2. Be aware of the specific tax deadlines for which
they are responsible.
3. Stay abreast, to the greatest degree possible, of
changes in tax laws that may directly affect their
business.
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Role of Hospitality Managers
The Internal Revenue Service (IRS) is the taxing
authority with which hospitality managers are likely most
familiar.
Among other things, the IRS requires businesses to do
the following:
File quarterly income tax returns and make payments
on the profits earned from business operations.
File an Income and Tax Statement with the Social
Security Administration.
Withhold income taxes from the wages of all employees
and deposit these with the IRS at regular intervals.
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Role of Hospitality Managers
Report all employee income earned as tips and withhold
taxes on the tipped income.
Record the value of meals charged to employees when
the meals are considered a portion of an employees
income.
Furnish a record of withheld taxes to all employees on
or before January 31 of each year (Form W-2).
It is the role of hospitality managers to stay abreast of
significant changes in tax laws and follow them to the
letter.
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Review of Learning Outcomes
Identify the purpose of capital budgeting.
Compute business owners investment rates of return.
Identify advantages and disadvantages of capital
financing alternatives such as debt versus equity
financing and lease versus buy decisions.
Determine the effects of taxation on a hospitality
business.
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