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.

Reflections on a long-gone enterprise

It's funny when you dig up some old pictures, and it makes you reflect on the events that led up to it, no matter how innocuous it may appear to be. The above image is a perfect example, taken of the back side of a business that had been recently shut down at the time.

There are apparently five shipping doors, consisting of three loading docks and two drive-in bays. However, only two of them were functionally available, being the two left-hand docks. Why was the operation constricted to only 40% of its potential shipping/receiving capacity? The first clue pops out when you take a closer look at the driveway under bay 3:



You have to look a bit closely, but there are spikes of rebar sticking out of the concrete, which served to secure a large dumpster that was seemingly always stationed under the bay door.

Bay 4's door was integrated into a large cardboard compactor that was inside, and thus could not be opened at all. In addition, a significant amount of garbage was left outside, which was one of the reasons the space between bays 4 and 5 was cluttered:



From the colour of the asphalt, it is readily apparently that the dust collection system inside (which was piped through a hole bored through the door next to bay 5) was not very efficient in collecting particulate matter, which engendered a completely different round of issues.

Between bays 4 and 5, a concrete pad was placed into the asphalt, on which an external dust collection system was mounted:




The bollards were steel tubes driven into the asphalt, into which concrete was poured. There was a secondary concrete pad poured between the first pad and the building.

The worst damage of all is seen at bay 5:



In this area are bollards, remnants of the same, as well as rebar punched into the asphalt. The upside-down T-bar at the top of the door also served to restrict the height of whatever could enter the building. In addition, there was a sorting line just inside the door, which prevented most equipment from being able to enter in any case. The shelter just in front of the door, which was used by maintenance staff for doing some outside work, did not help either.

The building had to be returned to the landlord at the end of its lease, which was only months away. The lease had a standard term, under which it had to be returned in the condition existing at the beginning of the term, and the changes undertaken by the tenant without the landlord's consent (including the above), known as "dilapidations", had to be removed. I was hired to help monitor the activity that needed to be done to fix all this. There was other work that needed to be done inside, but that is another story altogether!

The bay doors had to either repaired or replaced, to bring them back to working order. The asphalt in the back required substantial replacement, and the contractors really went to town on that:



And it really felt good to see the finished result:



But it does beg many questions as to what led to such a poorly designed system such as this. Several factors are quite apparent:

• The building is ideally designed to function as a warehouse. However, the business was oriented towards manufacturing, which has its own unique requirements.
• The business was being strangled by its waste collection system. The driveways on either side leading to the front of the building were very narrow, and thus any collection equipment could not be installed there. In addition, no thought was ever focused on using the space between bays 4 and 5 more efficiently with equipment positioned directly on the wall.
• With logistical capacity at only 40% of what it could have been, material flows both into and out of the facility were needlessly restricted. This had knock-on effects all down the line, which led to the loss of significant contracts with major customers arising from the inability to provide timely shipments.

There were other issues as well, and the industry in question was going through major shifts at the time, but I think the above were at the core of what was going on.

The latest federal Budget and capital investment

I haven't seen any good summaries on this topic on any of the standard websites, so here is my take on certain aspects of interest to management accountants.

Moving away from Class 29 CCA in 2016

This is rather interesting, in that the new Class 53 for manufacturing and processing equipment (effective for acquisitons after 2015 and before 2025) will be effective for at least ten years, at a 50% declining-balance amortization rate for the pool of assets concerned. This is a bit less attractive than the 25%-50%-25% amortization over a three-year period, but somewhat easier to calculate. Why they chose to move from the one method to the other is still not clear.

Why is it less attractive? It all comes down to simple math and standard capital investment appraisal techniques. For purposes of discussion, let us assume a gross investment (C) of CAD 100,000, a cost of capital (i) of 10%, and a combined federal/Ontario marginal tax rate (t) of 25% (ie, net of manufacturing and processing profits deductions).

The net present value after tax for investing in Class 29 assets is calculated using the formula

$ I \left [ 1-t\left (\frac{0.25}{1+i}+\frac{0.5}{\left (1+i\right)^2}+\frac{0.25}{\left (1+i\right)^3}\right) \right ] $

or approximately CAD 79,282.

Now let's take a look at the new Class 53, with its amortization rate (d) of 50%, subject to the half-year rule. The net present value after tax for that investment would be calculated using the formula

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

 or approximately CAD 80,113, which would an effective cost increase of about 1%.

The feds still maintain that the eventual fallback classification for such assets, for acquisitions after 2025, will be Class 43 at a rate of 30%. As they have been deferring this move for several years now, it remains to be seen whether it will ever come about, but the above formula would then suggest a net after-tax cost of about CAD 82,102, or 3.6% above the Class 29 amount.

The differences are not huge, and Canada's rates for such investments are still probably some of the most generous in the world. The real challenge will be getting Canadian managers to undertake any investment at all, which invites further discussion on our appetite for undertaking significant expansion and innovation. To date, there has been too much emphasis on improving the concessions for small businesses, but it has been argued that such measures constitute a disincentive for expansion, as too much activity is expended towards keeping such enterprises below the thresholds for applying higher rates, thereby limiting cash flows available for productive investments. That, however, is an argument for another day.

Integration of Eligible Capital Property within the CCA system

There will apparently be legislative proposals later on this year to deal with this matter, which will be quite welcome. It's been a long time coming for this idea to come about for getting rid of what was essentially a parallel régime. I look forward to seeing what the detailed measures will entail.

How will you cope under "cap and trade"?

This week's news that Ontario and Quebec will set up a joint "cap and trade" scheme to control carbon emissions is interesting, although lacking in such important information as details. I would have preferred the "carbon tax" option that BC has chosen, as it would be administratively simpler to run, but businesses here will now have to get ready for it. I foresee that we accountants, but more importantly the engineers, will need to really work in order to ensure that this works the way it is intended to.

Here's why:

• The businesses that will be subject to the scheme will have to self-report the amount of carbon emissions that they generate. Whether this is based on inputs or outputs, it means some rather detailed manufacturing reporting, and that's where the engineers will need to set up the appropriate systems.
• Businesses will be issued permits assigning given carbon allowances for what they are allowed to consume. Depending on the scheme's design, some permits may be given out for free, while others may be issued upon payment of a given price per tonne of carbon emissions involved. It you emit less carbon than you are permitted, you can sell the excess allowances on the open market. If you emit more carbon than you have allowances for, you will be assessed a fine, unless you purchase other businesses' excess allowances. That is where the accountants come in, to keep track of the company's exposure and ensure that everything is being properly reported.
• Over time, the amount of carbon allowances will be proportionately reduced, in order to compel reductions in the generation of emissions.

There are accordingly several risks and opportunities:

•  Who will qualify for free allowances?
• Will the scheme cover all emitters, or will certain exemptions or minimum thresholds apply?
• How efficiently will the open market for excess allowances work?
• As emissions caps are being progressively reduced, will it be cheaper to invest in new equipment in order to meet the targets, or will it be cheaper to pay the fines?
• Would it be worth your while to invest in new equipment now, if the market price for your excess allowances will generate a positive net present value?
• Similar concerns arise about the financial viability of investing in carbon offset projects and other methods of securing credits.

Quebec's scheme is interesting to look at, but Ontario has refused to indicate whether theirs will function the same. Stay tuned in six months' time.

Target Canada's interlocking relationships

Going back to the Pre-Filing Report submitted by Target Canada's imminent Monitor, here are some interesting aspects as to how an organization like that is structured.

Banking

Four banks were involved:

• Royal Bank of Canada
• Toronto-Dominion Bank
• JPMorgan Chase
• Bank of America

 Bank of America was the prime banker, into and out of which all funds ultimately flowed:

• CAD credit, debit and gift card transactions flowed through deposit-taking accounts at TD, which were swept into concentration accounts.
• Other CAD and USD  receipts flowed through deposit-taking accounts at RBC, which were swept into their respective concentration accounts.
• Funds from TD and RBC were transferred to the Bank of America on an "as needed" basis, in order to fund Target Canada's operations.
• There was an account at JPM dedicated to overseas vendor payments, which was funded out of the Bank of America.
• Bank of America handled all disbursements through several accounts (segregate according to method of payment and currency type), which were swept into concentration accounts. There was also a master account for currency conversion and funding JPM payments, as well as an account dedicated to payments to Starbucks under its licensing agreement for in-store sales.

There is nothing unusual about such arrangements - in fact, I first came across similar structures in the early 1980s, and they were very effective then in managing complex series of transactions. It is interesting, though, that the Canadian banks played an essentially subordinate role here.

Intercompany agreements

There was a master agreement in effect between Target Canada and one of the Target US operating subsidiaries that covered an extremely broad range of support services as well as a license for Target's intellectual property. The support staff were located at Target's head office in Minneapolis, as well as in India. It's interesting to observe that they were only in the process of obtaining approval from the CRA for an advance pricing agreement to assure that fees payable under the APA would be regarded as being at arm's-length. After over two years, one would think that such approval would have already been received.

There were also intercompany agreements in effect for the secondment of employees from Target US operations to Target Canada, where connected expenses were reimbursed, as well as for the management of its leased properties, its buying agency, and its design and development services.

All of these arrangements are quite normal in multinational companies, and they should be used more in Canadian-owned enterprises. That may tie in with the hollowing-out effect I mentioned previously.

Thoughts on capital investment appraisal

A while back, I posted about the techniques one must use when calculating appraisals in a Canadian context. It was somewhat simplified, as it pertained only to a single alternative. That is unrealistic, as the business world is more complex: 

• What if there are alternatives?
• Which one makes more economic sense?
• Assuming that benefits are equal among the alternatives, which project results in the lowest cost?
• What if these alternatives have different economic lives?
• Is leasing or buying the most economical choice?

For the first two questions, the answer is almost always the alternative with the greatest net present value on a discounted cash flow basis. The only plausible exception is where the project represents a major ground-breaking development, and that calls for strategic decision-making at the Board level. That is a discussion for another time.

For the other questions, there is a technique available that has been rarely discussed but is quite powerful, which calls for determining the Equivalent Annual Cost. Put simply, it is the net present value divided by the capital annuity factor, or

$ EAC = \frac{NPV}{A_{t,i}} $

where t = number of years, and i = cost of capital. The capital annuity factor is calculated as:

$ A_{t,i} = \frac{1-\left(\frac{1}{1+i}\right)^t}{i} $

If there is any salvage value at the end of the project, that can be factored in through using a sinking fund factor, calculated as:

 $ SFF_{t,i} = \frac{1}{\left(1+i\right)^t-1} $

This is useful for many scenarios:

• What if the asset requires periodic overhauls every few years, and in what circumstances is it cheaper to replace rather than overhaul?
• What commitments must be made for maintaining inventories of parts and maintenance supplies?
• What if a landlord provides rent-free periods at certain points in the lease?
• Are there conditional grants or other incentives that are paid subsequent to acquisition or improvement of an asset?
• Can the asset be sold at the end of its useful economic life, and would that value be different for the various alternatives?

These can be calculated in a rather straightforward manner. Let us take an example of deciding which of two types of storage tanks would represent a more economical investment. A steel tank costing CAD 10,000 with a salvage value of CAD 1,000 and annual operating costs of CAD 1,600 has an estimated useful life of five years. It is being compared to a stainless steel tank costing CAD 25,000 with a salvage value of CAD 2,000 and annual operating costs of CAD 100. Which is the better choice?



In this case, all other things being equal, the stainless steel tank has the lower EAC, and it should be the preferred choice.

For manufacturing and processing operations, assets fall under class 29, which has a different calculation. The result can be modified as follows:



 In this case, the end result would still be the same, but note how different the NPVs are for the capital investment.

This is not a new technique: in fact, it was taught to all CMAs and still represents part of the Body of Knowledge that we are expected to use in our work. It was discussed in much greater detail in A Practical Approach to the Appraisal of Capital Expenditures (C. Geoffrey Edge, V. Bruce Irvine (1981), ISBN 0-920212-29-8), which, having been last issued in 1989, does not seem to be widely available these days. I took one of its examples on this subject, and updated it to take into account the "half-year rule" now in effect for claiming first-year CCA, as well as more realistic rates for corporate tax and cost of capital. Otherwise, the logic is still sound.

I am publishing this because I cannot seem to find anything similar on the web, and this is just too useful not to attract a wider audience in the CPA community. Formulas are embedded, so that its working can be better understood.

Another sad point about Target Canada

Normally, reviewing bankruptcy and CCAA filings is rather depressing, but there are occasions where some details pop out that really are surprising.

Take the recent news about Target pulling the plug on its Canadian operations:



There's a throw-away observation on p. 16 of the Pre-Filing Report, which disclosed that "[Target Canada] does not have stand-alone accounting and treasury departments." These functions were handled out of Target's head office in Minneapolis, under an intercompany agreement.

Think about it: in establishing its Canadian operation, the US parent decided that it was not appropriate to set up a separate Finance function, whether for reasons of cost or operational efficiency. I have already been familiar with some larger companies setting up shared service centres for consolidating some aspects of their operations world-wide, but deciding to farm out the entire function to another country does not bode well for us CPAs here. This is suggesting a hollowing-out may be coming for many Canadian operations of foreign companies, on a scale we have not yet contemplated:

• spreadsheet and ERP applications have taken over many tasks that used to be consigned to clerical staff
• receivables and payables processing can be fully automated, to the point that remittance information can be transmitted to vendors for posting directly against outstanding invoices without human intervention
• banking transactions can be handled in similar fashion
• in short, paper-based transactions are essentially obsolete, and any that remain suggest that operations are not being competently managed
• posting and reconciliation can be handled anywhere, and I am already familiar with such operations being handled out of India, Malaysia and the Philippines by equally competent staff working for significantly less salary that would be the case here

Given these realities, what is left for professional accountants to do on our home turf? Is there still opportunity for developing Finance groups with a critical mass of CPAs that will benefit new Canadian organizations that are not in the public sector? This is definitely worth debating.