Calculating Initial Investment Costs
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ScribdTranslationsCalculating Initial Investment Costs
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ScribdTranslationsDetermination of initial investment
The term initial investment refers to the initial cash outlays required to undertake a capital investment. Our
study of capital budgeting will focus on projects with initial investments that occur only at time zero (early
in the life of the investment). The initial investment is calculated by subtracting all cash inflows that occur
at time zero from all cash outflows that occur at time zero.
The basic format for determining the initial investment is shown in table 1. The cash flows that are often
part of the initial investment include the installed cost of the new asset, the after-tax proceeds (if any) from
the sale of the old asset, and the change (if any) in equity. net work. Note that if there are no installation
costs and the company is not replacing an existing asset, then the cost (the purchase price) of the new
asset, adjusted for any change in net working capital, is equal to the initial investment.
INSTALLED COST OF A NEW ASSET
The installed cost of a new asset is equal to the cost of the new asset plus its installation costs. The cost of
the new asset is simply the purchase price of the new equipment or other fixed asset. Installation costs are
the accumulated costs incurred to put an asset into operation. The United States tax system (IRS) requires
a company to add installation costs to the purchase price of an asset to determine its depreciable value,
which is applied over a specific period of years.
INCOME AFTER TAX FROM THE SALE OF THE
OLD ASSET
Table 1 indicates that the after-tax income from the sale of an old asset decreases the company's initial
investment in the new asset, in the same way that the sale of an old car decreases the cost of purchasing a
new one.
This income includes money from the sale of the old asset and any applicable taxes or tax refunds related
to its sale. The proceeds from the sale of an old asset are the net cash inflows it provides. This amount is
net of the costs incurred in the process of eliminating the asset. Included in these disposal costs are
cleanup costs, such as those related to the removal and disposal of hazardous materials. These can be
substantial costs.
Table 1 Basic format to determine the investment
initial
Installed cost of new asset =
Cost of new asset
+ Installation costs
- Income after taxes from the sale of the old asset =
Income from the sale of the old asset
± Taxes on the sale of the old asset
± Changes in net working capital
Initial investment
Income from the sale of an old asset is normally subject to some form of tax. This tax on the sale of an old
asset depends on the relationship between the sales price and the book value, and the current tax
regulations.
Value in books
The book value of an asset is its strictly accounting value. It is calculated using the following equation:
Book value = Installed cost of the asset - Accumulated depreciation (1)
Example. Hudson Industries, a small electronics company, purchased a machine tool
2 years ago with an installed cost of $100,000. The asset was depreciated with the MACRS system
considering a recovery period of 5 years. It is shown that, for a period of 5 years according to the MACRS
system, the depreciation of the installed cost would be 20 and 32% during years 1 and 2, respectively.
In other words, 52% (20% + 32%) of the $100,000 cost, that is, $52,000 (0.52 x $100,000), would
represent the accumulated depreciation at the end of year 2. Substituting into equation 1, we obtain:
Book value = $100,000 - $52,000 = $48,000
The book value of Hudson's asset at the end of year 2 is therefore $48,000.
Basic tax rules
Any of three tax situations may arise when a company sells an asset. These situations depend on the
relationship between the asset's sales price and its book value. Table 2 defines and summarizes the two
main ways of taxing income and their associated tax treatments. The tax rates assumed throughout this
book are included in the final column. There are three possible tax scenarios. The asset can be sold: 1. at a
figure greater than its book value, 2. for its book value, or 3. at an amount less than its book value. We
will illustrate it with an example.
Table 2 Tax treatment of asset sales
Form of income Definition Tax treatment Assumptive tax rate
An old asset that Hudson Industries purchased 2 years ago for $100,000 has a current book value of
$48,000. What will happen if the company decides to sell it and replace it? The tax consequences depend
on the sale price. Figure 11.3 illustrates the taxable income resulting from four possible sales prices in
light of the price of
initial purchase of $100,000 and its current book value of $48,000. The tax results of each of these sales
prices are described in the following paragraphs.
Pricing the asset above its book value If Hudson sells the old asset for $110,000, he makes a profit of
$62,000 ($110,000 _ $48,000). Technically, this gain comes from two sides: a capital gain and
recaptured depreciation , which is the portion of the sales price above the book value and below the
initial sales price. For Hudson, the capital gain is $10,000 ($110,000
of the sales price _ $100,000 of the initial purchase price); the depreciation recovered is $52,000 (the
$100,000 of the initial purchase price _ $48,000 of the book value).
Figure 3 shows that both the capital gain of $10,000 and the recovered depreciation of $52,000 are below
the sales price of $110,000. The total gain above the book value of $62,000 is taxed as ordinary income at
a rate of 40%, resulting in $24,800 of taxes (0.40 _ $62,000). These taxes should be used to calculate the
initial investment of the new asset, using the format in Table 1. In effect, taxes increase the amount of the
company's initial investment in the new asset by reducing the proceeds from the sale of the old asset.
If, instead, Hudson sells the old asset for $70,000, he will experience a gain above book value (in the form
of recaptured depreciation ) of $22,000 ($70,000 _ $48,000), as shown below the sales price of $70,000.
in figure 3. This gain is taxed as ordinary income. As:
Figure 3
It is assumed that the company is in the 40% tax bracket, taxes on
the profit of $22,000 is $8,800 (0.40 _ $22,000). This tax amount should be used in calculating the initial
investment of the new asset.
Selling the asset at its book value If the asset is sold at its book value of $48,000, the company neither
gains nor loses. There is no loss or gain, as shown below the sale price of $48,000 in Figure 11.3. Since
there are no taxes on the sale of an asset at its book value , there is no tax effect on the initial investment
of the new asset.
Selling the asset for less than its book value If Hudson sells the asset for $30,000, he will experience a
loss of $18,000 ($48,000 _ $30,000), as shown below the sales price of $30,000 in Figure 3. If it is a
depreciable asset used in the business, the business can use the loss to offset ordinary operating income. If
the asset is not depreciable or is not used in the business, the business may use the loss only to offset
capital gains. In either case, the loss will save the company $7,200 (0.40 _ $18,000) in taxes. And if
current operating profits or capital gains are not enough to offset the loss, the company will be able to
carry these losses forward in past or future tax years.
CHANGE IN NET WORKING CAPITAL
Net working capital is the difference between the company's current assets and liabilities. Capital
investment decisions generally cause changes in the company's net working capital. If a company acquires
new machinery to expand its level of operations, it will experience an increase in the levels of cash,
accounts receivable, inventories, accounts payable and accumulated debts.
These increases are a consequence of the need for more cash to support the expansion of operations, more
accounts receivable and inventories to support the increase in sales, and more accounts payable and
accumulated debts to support the increase in disbursements for meet the growing demand for the product.
Increases in cash, accounts receivable, and inventories are cash outflows , while increases in accounts
payable and accrued debts are cash inflows .
The difference between the change in current assets and the change in current liabilities is the change in
net working capital . Typically, as a company grows, current assets increase more than current liabilities,
resulting in an increase in net working capital investment. This increase in investment is treated as an
initial outflow.2 If the change in net working capital is negative, it would be shown as an initial inflow.
The change in net working capital (regardless of whether it increases or decreases) is not taxable because
it simply implies a net accumulation or reduction of current accounts.
Example 4
Danson Company, a metal products manufacturer, is considering expanding its operations. Financial
analysts assume that changes in current accounts, summarized in Table 11.3, will occur and be maintained
over the life of the expansion. Current assets will increase by $22,000, and current liabilities will increase
by $9,000, causing an increase of $13,000 in net working capital. In this case, the change will represent an
increase in net working capital and will be treated as a cash outflow in the calculation of the initial
investment.
Table 3 Calculation of the change in working capital
net for Danson Company
CALCULATION OF THE INITIAL INVESTMENT
A wide variety of taxes and other considerations go into calculating the initial investment.
The following example shows the calculation of the initial investment according to the format in table 1.
Powell Corporation, a manufacturer of aircraft components, is trying to determine the initial investment
required to replace an old machine with a new model. The purchase price of the new machine is $380,000,
and an additional $20,000 will be required to install it. It will be depreciated over a recovery period of 5
years in accordance with the MACRS scheme. The old machine was purchased 3 years ago at a cost of
$240,000 and has been depreciated according to the MACRS method considering a recovery period of 5
years. The company found a buyer who is willing to pay $280,000 for the machine and take care of the
removal costs. The company expects that, as a result of the replacement, its current assets will increase by
$35,000 and its current liabilities will increase by $18,000; These changes will generate an increase in net
working capital of $17,000 ($35,000 _ $18,000). The company pays taxes at a rate of 40%. The only
component that is difficult to obtain in the calculation of the initial investment is the tax. The book value
of the current machine can be obtained using the depreciation percentages of 20, 32 and 19% for years 1, 2
and 3, respectively, according to table 2. The resulting book value is $69,600 ($240,000 _ [(0.20 _ 0.32 _
0.19) _ $240,000]). The sale results in a profit of $210,400 ($280,000 _ $69,600). Total taxes on the gain
are $84,160 (0.40 _ $210,400). These taxes must be subtracted from the $280,000 sales price of the
current machine to calculate the after-tax income derived from this sale. Substituting the relevant amounts
into the format in Table 1, we obtain an initial investment of $221,160, which represents the required net
cash outflow at time zero.
