Capital investment appraisal: the importance of assessing it right

I did some work over on Wikipedia on this topic with respect to the Canadian context, and thought it might be a good idea to expand upon it here.

Capital investment projects are always assessed on their cash flows. As we know, cash flows are segregated into streams arising from activities in:

• operations
• investment, and
• financing

The initial assessment of a project will match up the expected streams from operations and investments, in order to assess viability. Streams relating to financing will become relevant when assessing the best option for the acquisition of the assets (ie, lease vs buy, debt vs equity, and so on), but that is by definition the second step of the process, after the initial appraisal has been completed.

Let us assume the following factors for use in our calculations or capital cost allowance fhere:

• I = Investment 
• d = CCA rate per year for tax purposes 
• t = rate of taxation 
• n = number of years
• i = cost of capital, after-tax rate of interest, or minimum rate of return (whichever is most relevant)

Full-year rule

When CCA is calculated at the maximum rate, the values claimed by year for a specific class under the full-year rule will be broken out as follows:

$ Id + Id(1-d) + Id(1-d)^2 + \cdots + Id(1-d)^{n-1} $

Therefore, the tax shield in year n = $ Itd(1-d)^{n-1} $, and the present value of the taxation credits will be equal to $ Itd \sum\limits_{n=1}^\infty \frac{(1-d)^{n-1}}{(1+i)^n} $.

As this is an example of a converging series for a geometric progression, this can be simplified further to become:

$ PV = \frac{Itd}{i+d} $

The net present after-tax value of a capital investment then becomes:

$ I  \left (1-\frac{td}{i+d}\right ) $

Half-year rule

For capital investments where CCA is calculated under the half-year rule, the CCA tax shield calculation is modified as follows:

$ \begin{align}
PV & = \frac{1}{2}\left (\frac{Itd}{i+d}\right ) + \frac{1}{2}\left (\frac{Itd}{i+d}\right )\left (\frac{1}{1+i}\right ) \\
& =\frac{Itd}{i+d}\left [\frac{1}{2} + \frac{\frac{1}{2}}{1+i}\right ] \\
& =\frac{Itd}{i+d}\left [\frac{\frac{1}{2}\left (1+i\right ) + \frac{1}{2}}{1+i}\right ] \\
& =\left (\frac{Itd}{i+d}\right )\left (\frac{1+\frac{1}{2}i}{1+i}\right ) \\
\end{align} $

Therefore, the net present after-tax value of a capital investment is determined to be:

$ I \left [ 1-\left (\frac{td}{i+d}\right )\left (\frac{1+\frac{1}{2}i}{1+i}\right ) \right ] $

Specialized calculations

The methods shown above are the default calculations used for standard pools of undepreciated capital cost using the declining-balance method for accounting for CCA. There are certain classes where different calculations will be employed:

• Class 13 (leasehold improvements) - Over the original lease period plus one renewal period (Minimum 5 years and maximum 40 years, but half-year rule applies)
• Class 14 (franchises, concessions, patents and licenses) - Length of life of property (no half-year rule applies)
• Class 29 (effectively recognized over three years, at 25%/50%/25%)

These are instances where standard spreadsheet calculations will still need to be employed. These are quite well presented in most financial management texts.

There are also special rules for companies that are involved with industrial mineral mines or timber limits and cutting rights. In addition, resource companies will need to assess the impact of the resource and processing allowances that are available to them. These rules are beyond the scope of this article.

Assessing a suitable price for real estate income properties

Having once worked for several companies that were involved in real estate acquisition and management, it has always amazed me how many deals are arrived at without a proper financial assessment of cash flows and risks. Fortunately, there are some tools available to help make the analysis more rigorous and dispassionate.

The capitalization rate ("cap rate" for short) is very useful in that regard. In order to calculate it, you must first assess what the net operating income is for the property you are investigating, which is simply the operating profit before amortization and interest expense. You then determine what the NOI will be over the timeline you are assessing.

Assuming that a = NOI and i = cap rate, therefore the price of a property should be equal to

$ \large \sum\limits_{n=1}^\infty  \frac{a}{(1+i)^n}  $

which is the infinite series:

$ \large \frac{a}{(1+i)} \,+\, \frac{a}{(1+i)^2} \,+\, \frac{a}{(1+i)^3} \,+\, \frac{a}{(1+i)^4} \,+\, \cdots $

This is a geometric series with common ratio $ \frac{a}{(1+i)} $. The sum is the first term divided by (one minus the common ratio):

$ \large \frac{a/(1+i)}{1 - 1/(1+i)} \;=\; \frac{a}{i} $

You will then be in a position to compare the cap rate with the financing rates that is being proposed for the debt and equity components of the acquisition, in order to assess the viability of the deal.

What does this mean in practice? According to a recent article in The Globe and Mail, cap rates for Canadian commercial properties are currently in the range of 5.75% - 7.50%. Therefore, the purchase price for such a property should be its NOI divided by its cap rate. Conversely, the NOI of a property divided by its purchase price should equal the cap rate. Of course, if NOI varies by year, you will need to set this out in a spreadsheet to compute the present value of NOI over multiple periods, but that is relatively simple to produce these days.

If, on the other hand, the above calculations show that the cap rate for a property falls outside the acceptable range, it should lead to negotiations for a more appropriate price, or choosing to walk away from the deal.

The B and C teams

Every so often an observation just leaps out at you when you are reading an article off the beaten path. That happened today when I read Margaret Wente's latest column in The Globe and Mail. She was writing about the Hemda Centre for Science Education in Tel Aviv, and there was a very striking comment as to how they identify who should attend:

Canada has nothing like Hemda. That’s too bad, because we could use a lot more of the creativity and innovative mindset that Hemda fosters.

“We recruit for the ability to solve problems,” Tehilla Ben Gai, the school’s director, told me as she showed me around the bright and airy school. Its 1,100 students, who are in Grades 10 to 12, have all been assessed in person to see if they have the right stuff. “B and C students are sometimes smarter than A students,” she says. “We’re looking for students who are creative – and we teach them that science is fun.”

Contrast that philosophy with what is happening these days over here, where absolute perfection seems to be demanded of anyone who is applying for a position anywhere. This organization is really doing its diligence to see who can really succeed, and many times being on the A team will not truly help.

Corporate structure: to simplify or not?

When considering how to structure an operation, I normally prefer the single-entity route - after all, Occam's Razor is a practical method that works. However, there are circumstances that may dictate establishing multiple entities in a group:

• Is it necessary to ring-fence certain assets? This can be as simple as placing an operation in an operating company, and the acquisition of the building it is operating from in a separate company. Of course, there would have to be a valid lease executed between the two companies, with rent and other connected charges being properly paid from one to the other, but it is an excellent strategy for creditor-proofing.
• Does a company have a particularly valuable brand or other intellectual property (ie, patents, trademarks, etc)? These can be vested in separate management companies, with appropriate licensing agreements being executed between companies. All the fast food franchise operations (such as Tim Hortons or McDonald's) practice this.
• Does the head office of a group perform significant services on behalf of its subsidiary operations? There should be a valid intercompany services agreement in place, with services being charged at appropriate rates.

Much of this strategy has arisen from transfer-pricing litigation by the various taxation authorities in cross-border cases, but the logic is the same even when done within the same country, given the provisions in income tax legislation mandating fair market valuation.

The book that inspired my career

One of the (few) positive aspects of moving is that you get to spot things you haven't touched in years. One of them is a Pelican book I picked up back when I first started pursuing my studies in accountancy.¹

There are some great quotes in it that provided both warning and inspiration about the path I would take, and they still hold true today.

First of all, there is a warning as to what an accountant must not be, which was first noted by Elbert Hubbard:

A man past middle age, spare, wrinkled, intelligent, cold, passive, non-committal, with eyes like a codfish; polite in contact but at the same time unresponsive, calm and damnably composed as a concrete post or a plaster of Paris cast; a petrification with a heart of feldspar and without charm of the friendly germ, minus bowels, passion or a sense of humour. Happily they never reproduce and all of them finally go to Hell.

 On the other hand, a more modern description of a management accountant by Joseph R. Dugan has served to be the inspiration for my career:

A highly skilled technician - well educated, complex, confident, intelligent, optimistic - who abhors detailed direction. He expects to be influenced, persuaded and enlightened. He wants to be confronted with choices and alternatives, demanding freedom to structure his work, select his alternatives, present his solutions and speak for himself. He refuses to be considered an automaton who is supposed to respond eagerly to orders, edicts and ultimatums.

Looking back, I would say I have been fulfilling the latter quite well, but I can also confirm that there are still too many people - accountants included - that still stick to the first description (although I would say that middle age has nothing to do with the underlying attitude).

Finally, an observation about the nature of profit is provided from Peter Drucker, who pointed out that it serves three purposes:²

1. It measures the net effectiveness and soundness of a business's effort.
2. It is the premium that covers the costs of staying in business.
3. It ensures the supply of future capital for innovation and expansion - either directly or indirectly.

I have never seen this explained so succinctly anywhere else, and it has certainly given greater focus to the approach I have taken to the work I have performed.

All in all, this was a refreshing reminder of inspirations and aspirations both past and present.

---

1 John Sizer, An Insight into Management Accounting, Penguin Books, London, 1969, ISBN 0-14-021087-3.^↩
2 Peter Drucker, The Practice of Management, Mercury Books, London, 1961, pp. 65-9^↩

Practical applications of the cloud

Although many people still prefer to store files solely on their own hardware (whether workstation, laptop, tablet, and so on), there are useful instances where it is more efficient to use cloud storage:

• collaboration within a group
• resource for web presentations
• practical access for clients
• free storage for small accounts (ie, up to 2Gb)

Box.com is one example, and you can now embed your files from their storage into your own work on the web, such as this:


Another great one can be found at Scribd, and embedded content from their storage will look like this:

Robert. A. Ellerby, CPA, CMA

Let's not forget Google Docs:

There are others, but I find these three to be quite useful.

Thoughts on the 2013 Ontario Budget

The budget that Charles Sousa presented last week is geared more towards ensuring the survival of the present minority government. This is obvious from the goodies that were announced, such as the mandated 15% reduction in auto insurance premiums. The law of unintended consequences dictates that this decrease will be made up elsewhere by the various insurance companies - another example of an initiative by the Province that is not clearly thought out for any reason other than to preserve potential Liberal votes for the next election.

Probably the most crucial issue is that of productivity in the business sector. The budget does acknowledge this, together with the issues of underinvestment in R&D and M&E compared to US-based businesses. Unfortunately, neither the provincial nor federal levels of government can influence this more than they have already done — their incentives are already very generous — other than to introduce sanctions for not doing so, which will be difficult to either conceive or be accepted.

There is little to report about tax changes — other than for tax rates and credits, Ontario automatically parallels federal taxation rules. The only significant item to note is what will happen to the calculation of Employer Health Tax. Beginning in 2014:

• the portion of total Ontario payroll that is EHT-exempt will rise from CAD 400,000 to CAD 450,000
• the exemption will be adjusted for inflation once every five years,  using the Ontario Consumer Price Index
• private-sector employers (other than registered charities) with a total Ontario payroll greater than $5 million will no longer be able to claim the exemption

How does this translate in terms of total headcounts that will be impacted? According to Statistics Canada, average hourly weekly earnings for 2012 in Ontario amounts to CAD 908.00, which translates to an annual amount of CAD 47,216. Therefore:

• the annual exemption in 2014 is equivalent to a headcount of just over 9 (450000/47216 = 9.53)
• the maximum threshhold beyond which the exemption will cease to have effect is equivalent to a headcount of just over 105 (5000000/47216 = 105.90)
• the EHT rate continues to be 1.95%

Considering how risk-averse most Canadian small businesses tend to be, there may be a lot of thought being given as to whether to hire employee #106, as that will mean an immediate increase of CAD 8775 (450000*0.0195 = 8775) in their total EHT liability. That is probably the wrong message to give to employers, and definitely a negative message to those people who are trying to find work after coming through the recent Great Stagnation.

Again, this strikes me as a measure that was not fully thought out. Let's see if this survives the coming budget debate.