Managerial Application 151

Market-Based Capital Budgeting

The real key to creating corporate wealth is to apply a market-based approach to capital budgeting. The power of the market-based capital budgeting concept stems from the fact that managers cannot know if an operation is really creating value for the corporation until they calculate and apply the true cost of capital to all assets employed. To grow the company in a value-maximizing manner, the firm must weigh the answers to two important questions.

Question No. 1: What is the true cost of capital? The cost of borrowed capital is easy to estimate. It is the interest paid, adjusted to reflect the tax deductibility of interest payments. The cost of equity capital is more difficult to estimate. It is the return shareholders could get if they invested in a portfolio of companies about as risky as the company itself. From this perspective, the relevant cost of capital is its opportunity cost.

Question No. 2: How much capital is tied up in the operation? Capital traditionally consists of the current value of real estate, machines, vehicles, and the like, plus working capital. Proponents of market-based capital budgeting say there is more. What about the money spent on R&D and on employee training? For decision-making purposes the return on all investments must be calculated over a reasonable life, say 3 to 5 years.

When both questions are answered, multiply the amount of capital from Question No. 2 by the rate of return from Question No. 1 to get the dollar cost of capital. The market value added by the capital budgeting process is operating earnings minus these capital costs, all on an after-tax basis. If the amount of market value added is positive, the operation is creating wealth. If market value added is negative, the operation is destroying capital.

The key is to ensure that the firm's investments generate a profit above and beyond the explicit and implicit cost of capital.

See: Dow Jones Newswires, "Kerr-McGee Announces 2002 Capital Budget," The Wall Street Journal Online, January 8, 2002 (http://online.wsj.com).

Gourmet Foods already owns a piece of land that is suitable for the new store. When evaluating the new retail facility, should the cost of the land be disregarded because no additional cash outlay would be required? Certainly not, because there is an opportunity cost inherent in the use of the property. Suppose that the land could be sold to net $150,000 after commissions and taxes. Use of the site for the new store would require foregoing this inflow, so the $150,000 must be charged as an opportunity cost against the project. The proper land cost is the $150,000 market-determined value, irrespective of historical acquisition costs.

A further potential problem involves the effects of the project on other parts of the firm. For example, suppose that some of the new outlet's customers are already customers at Gourmet Foods' downtown store. Revenues and profits generated by these customers would not be new to the firm but would represent transfers from one outlet to another. Cash flows produced by such customers should not be treated as incremental in the capital budgeting analysis. On the other hand, having a new suburban store might actually increase customer awareness in the local market and thereby attract additional customers to the downtown outlet. In this case, additional revenues projected to flow to the downtown store should be attributed to the new suburban facility. Although they are often difficult to identify and quantify, externalities such as these are important and must be considered.

A fourth problem can relate to the timing of cash flows. Year-end accounting income statements seldom reflect exactly when revenues or expenses occur. Because of the time value of money, capital budgeting cash flows should be analyzed according to when they occur. A time line of daily cash flows would in theory be most accurate, but it is sometimes costly to construct and unwieldy to use. In the case of Gourmet Foods, it may be appropriate to measure incremental cash flows on a quarterly or monthly basis using an electronic spreadsheet. In other cases, it may be appropriate simply to assume that all cash flows occur at the end or midpoint of every year.

Finally, tax considerations are often important because they can have a major impact on cash flows. In some cases, tax effects can make or break a project. It is critical that taxes be dealt with correctly in capital budgeting decisions. This is difficult because the tax laws are extremely complex and are subject to interpretation and change. For example, salvage value has no effect on the depreciable basis and hence on the annual depreciation expense that can be taken. Still, when performing a cash flow analysis, the market value of an asset at the end of the project represents a relevant expected cash inflow. Any difference between salvage value and depreciated book value at the end of a project is currently treated as ordinary income and is taxed at the firm's marginal tax rate. The staff in charge of evaluating capital investment projects must rely heavily on the firm's accountants and tax lawyers and also must develop a working knowledge of current tax law.

Accounting income statements provide a crucial basis for estimating the relevant cash flows from investment projects. This information must be adjusted, however, to carefully reflect the economic pattern of inflows and outflows so that value-maximizing investment decisions can be made. Though a formidable task, firms can and do overcome problems posed by sunk costs, opportunity costs, spillovers, and tax considerations. To illustrate, the following section offers a simplified example of cash flow estimation.

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