Current considerations for appraising capital expenditures

As I was alluding to yesterday, the appraisal of capital expenditures has become much more complex since CMA Canada last explored the topic in 1981. Here are some aspects to consider:

1. The greater participation of the public sector has called for different types of focus. While the cost of capital will tend towards the risk-free rate, there are also greater requirements for considering optimism bias and sensitivity analysis in different components of proposals, the allocation of risks that arise in public-private partnerships, and consideration of relevant benefits to society (including discussion of what is not relevant).
2. In the private sector, more rigorous pre-acquisition analysis is required to determine which components are capital and which are expense, for both financial reporting and tax purposes. This is effectively a 2x2 grid, and there is very little summary literature on the topic.
3. In the private sector, the after-tax cost of capital will need to be risk-adjusted depending on the nature of the investment. While this is largely a matter of judgment, some rules of thumb for annual rates that have arisen over time are 40% for venture capital and 50% for angel investments. Aside from those, there is the risk of being overly conservative in the assessment of relatively straightforward proposals, as well as from conflating financing issues (government grants, refundable tax credits, and pre-approved financing) with operations issues.
4. The tax shield arising from the availability of capital cost allowance is well-settled doctrine, whether through the full-year, half-year or other available methods of calculation. Very little work has been done in assessing the calculations under the US MACRS régime, for those Canadian companies that are fully integrated into US operations for tax purposes, but that could be relevant in certain circumstances.
5. Equivalent annual cost calculation is a powerful assessment technique that is still little discussed or applied.
6. Very little discussion has been given to the different types of capital investment that are undertaken. Som principal categories I have been familiar with include new business, expansion, process improvement, replacement, investment properties, regulatory compliance, and general corporate requirements (eg, head offices, branding, and company-wide IT or communications structures). In any case, different techniques are available for different purposes, and their application should be given detailed discussion.
7. Financial reporting under IFRS (but even before that, under the old CICA Handbook) calls for assessment of fair value and impairment of assets under specified conditions. These are important limits that must be considered in any risk analysis for acquisitions.

If anyone can think of other issues that should be raised, I would appreciate hearing about them.

Updates:  Typo corrected; "process improvement" and "investment properties" added in investment categories; give examples of non-relevant financing issues.

A Body of Knowledge passé?

Several decades back, CMA Canada was doing extensive work in analyzing and compiling best practices for management accounting, and established the CMA Canada Research Foundation to focus on that work. In addition to commissioning various studies, it also issued the Management Accountants Handbook and Management Accounting Practices Handbook for CMAs to abide by. They're quite prominent in my library.

I was recently wondering what is happening to that focus, now that all CMAs, CAs and CGAs are now part of CPA Canada. It turns out that notice was given in 2013 that the Foundation intended to surrender its charter. That has not happened yet, but it appears that it will lapse because of non-continuance under the Canada Not-for-Profit Corporations Act.

That's not all. The Handbooks themselves have never been updated since 1998, although electronic copies of the contents were always available from the CMA Canada website. That site is no longer available, and the new CPA Canada Store does not have access to them.

That's a pity. There was a lot of great advice that came out of this work, and much of the research was seminal in developing management accounting as we know it today. One study in particular, A Practical Approach to the Appraisal of Capital Expenditures, deserves to be updated to cover today's broader range of issues.

I hope CPA Canada revives access to this work. Otherwise, it would appear that our amalgamation was in reality a takeover.

Better analysis using Gnuplot

My recent posting using images generated from Gnuplot was rather basic. After examining its quite voluminous documentation somewhat cursorily, I have been able to significantly improve the output.

For example, the impact of tax rates and cost of capital on investment in Class 29 assets is illuminated through the use of colour:

Adding a 2D heatmap with the original 3D chart really does clarify the nature of the impact. By specifying different colours to different ranges of after-tax cost, we can more easily gauge the effects.

Here it is for Class 53:

You can easily see that the colours are shifting to the left, thus showing that the net after-tax cost is generally becoming cheaper.

And for Class 43:

 

You can note the impact quite distinctly between the three graphs.I have only just begun to explore this particular application, but I am already impressed with its power.

A follow-up on the impact of the federal budget

Last spring, I published a post on the impact of changes in capital cost allowance rates on the after-tax cost of investment. I attempted to quantify the impact, but I have wondered since about what would happen if the variables relating to tax rates and cost of capital changed, and how to express that clearly.

I have recently come across gnuplot, an open-source program that helps to chart questions like this, and inputted the data. I decided to plot all possible combinations from 1% to 99% for both cost of capital and composite corporate tax rates.

For the current Class 29 framework, the chart looks like this:

There are two things that immediately stand out:

• as the tax rate rises, the net after-tax cost falls; and
• as the cost of capital rises, the net after-tax cost increases as well.

For comparison, here is the impact on Class 53 assets, which is scheduled to be in effect from 2016 to 2024:

Note that this reduces the net after-tax cost attributable to higher costs of capital. This is especially important when such costs are weighted for risk.

And what about Class 43, which is supposed to return in 2025? While very theoretical, because of the recent change in government in Ottawa, here is what it would look like:

 

You can see immediately that the cost of capital aberration returns.For that reason alone, I would venture to guess that that option will never return to the Canadian tax structure.

All of these charts do highlight a major flaw in the current system, which all political parties in Canada have failed to see: as lower tax rates make the net after-tax cost of investment much more expensive, that means that current rate reductions given to manufacturing and small business are actually making it more expensive for them to invest in more productive assets. The UK, probably for that very reason, decided recently to abolish its preferential small business rate, and have opted to bring in concepts such as the "patent box" to assign lower tax rates based on the results of specified investments.

That may well be worth implementing here.

"The motherboard is fried."

I had some downtime this past week, when the HP laptop suddenly failed to boot. This was unexpected, and I had to take it in for the first time to have it looked at. The above headline summarizes the result. Thankfully, I was able to get my files retrieved, and they now lie on a nice little(!) 32Gb USB drive.

It had served me well for almost five years, and it was just upgraded to Windows 10 last month. That was a smooth process, although it took almost two hours to perform. Thankfully, I'm rather patient.

After investigation, I settled on a Lenovo Windows 7 Pro laptop with Intel i5. I normally prefer AMD chips, but I've learnt that they run hotter and are probably better suited for desktop workstations. That's interesting information to keep in mind for the future.

Within 24 hours, I now have it running on Windows 10, as I was informed that the laptop qualified for immediate upgrade. All other applications I required, in their latest versions, have also been downloaded and installed. They are all legal as well: I am a fan of open source apps, and they operate very well these days! Together with a second monitor, I'm now back in business.



 

Corporate stupidity: It's only gotten bigger

The recent news about how Volkswagen gamed their vehicles' software for the diesel emissions tests has been distressing, even causing some serious discussion about whether the diesel engine market itself will survive. The fact that these engineers could devise such software was perversely brilliant, but such abilities could have been better used to work on solutions that could reduce NO_x emissions, which was supposed to be the point.

I wish I could say that this type of behaviour is unusual, but it has always existed at one scale or another. Here are some interesting stories I've been told over the years.

Bankers and their ability to handle money

Leaving aside bankers' predictable habits of lending against the security of assets that are ready to tank (as when a real estate bubble is ready to burst), there are other instances that can really make you shake your head. Take in the mid-60s, when the Toronto-Dominion Centre was being constructed.



One contractor was given the job of finishing TD's executive offices, where the architect specified mirrored surfaces with bronze glass, which would coordinate with the outer skin of the buildings. To their dismay, the mastic used to bind the glass to the underlying substrate was tainted, which caused the mirrors' silvering to blotch and develop black spots  quite badly throughout the office layout. As the mastic had set, nothing short of dynamite could have removed it, so any resulting warranty repairs had the potential to render the contractor insolvent.

They were ready to face the music when TD's Chairman came to inspect how things were coming along. To their surprise, he exclaimed, "I don't like it! It's too dark in here. I want it all replaced with something lighter, and I don't care how much it costs!"

It was replaced, and, as extras in a contract always fetch higher margins, that year turned out to be that contractor's most profitable in years. They were still laughing about how that turned out twenty years later, when I first heard the story.

Misguided priorities of management

Something a little more in keeping with my line of work always has the capacity to surprise. For instance, auditors' standard practice has always included preparing a management letter at the end of an annual audit which gives points that they hope will be useful for the client. When a former boss of mine (who, alas, is now deceased) was still a hard-working CA for one of KPMG's predecessors, he was involved in an audit for Cochrane-Dunlop, which used to be one of the larger hardware distributors in Canada.

At the end of that particular year's audit, they had assembled quite a list of suggestions to help the company operate in a more tax-efficient manner. However, when they made their presentation, they could not help but notice that the Chairman's face was getting redder as time went on. He suddenly started shouting: "I completely object to what you are saying! I love this country, and I consider it my duty to pay as much tax as I possibly can to support it!" The audit team promptly hushed up, and the meeting wound up faster than they had planned.

Some subsequent history to note: Cochrane-Dunlop went bankrupt in 1987. Its industrial products division was sold to C.N. Weber (now known as Weber Supply), and the consumer products division (which had serviced Dominion Hardware, now part of PRO Hardware) was shut down. It makes you wonder what else there may have been that caused their priorities to be so fundamentally off base.

A great use of visual analysis

I've always fancied myself to be a visual - even symbolic - thinker, and am always looking for ways to express ideas and trends in that manner, as words can often fail to express what is really going on. I recently came across some work that someone did to explain what happened in the 2010 UK general election as voters shifted allegiances among the three main parties.

For example, here are the shifts by constituency between the Conservative and Labour parties, using Butler swing analysis:




You can plainly see that Labour support was eroding almost everywhere in the country. The black constituencies are those held by the Speaker of the House (whose campaign is generally not contested by the other parties), and one where the vote was delayed due to unforeseen circumstances. The constituencies in Northern Ireland are not shown, as the politics there are quite different from those in Great Britain itself.

This analysis can be extended to assess the relative strengths of other parties, such as the shifts between the Conservatives and the Liberal Democrats:




Here you can see that the results are more mixed, and hence more interesting. But here is the comparison between Labour and the Liberal Democrats:




When you compare the first and third charts, you can see that Labour support was vanishing across a wide swath of England and Wales, with votes moving to the other two parties. This greatly explains the outcome of that election.

I've taken a look to see if anyone worked up a similar analysis for the 2011 Canadian general election, but nothing is available. Technically, it should not be that difficult to work out, as Elections Canada does provide lots of baseline data online. This could prove to be a useful exercise.