Capital Investment, Leasing, and Taxation Chapter 12

Matakuliah : V0282 - Manajemen Akuntansi HotelTahun : 2009 - 2010

• Capital Budgeting• Capital Investment• Financing Alternatives• Taxation

Chapter Outline

Learning Outcomes

• Identify the purpose of capital budgeting.• Compute business owners’ investment rates of return.• Identify advantages and disadvantages of capital

financing alternatives such as debt versus equity financing and lease versus buy decisions.

• Determine the effects of taxation on a hospitality business.

Capital Budgeting

• In business, capital simply refers to money. • Those who invest their capital are, not surprisingly,

called capitalists, and the economic system that allows for the private ownership of property is called capitalism.

• As is the case in most industries, investing money in hospitality businesses can be risky.

• Capital budgets are used to plan and evaluate purchases of fixed assets such land, property, and equipment.

Capital Budgeting• Purchases of this type are called capital expenditures and,

as you learned previously, are recorded on a business’s balance sheet.

• Capital budgeting is the essential process by which those in business evaluate which hospitality operations will be started, which will be expanded, and which will be closed.

• In nearly all cases, business owners seek returns on their investments which are large enough to justify the continued investment of their capital.

Capital Budgeting

• In general, capital budgeting techniques can be classified as those that are directed toward one or more of the following business activities: – Establish a business (new venture, sometimes funded

by venture capitalists)– Expand a business (increase revenues)– Increase efficiency (reduce expenses)– Comply with the law (mandated change)

Capital Investment• Investors seek to balance the concepts of risk, with that

of reward (increase vs. decrease in value).• In most cases, as the amount of risk involved in an

investment increases, the return on that investment also increases.

• As an investor you would ultimately seek to compare the cost of making an investment today against the stream of income that the investment will generate in the future.

• To best make this “in the future” value comparison, or time value of money, which is the concept that money has different values at difference points in time.

Time Value of Money

• To illustrate the time value of money concept, assume that you have won $10,000 in the state lottery. Your options for collecting payment are:– Receive $10,000 now, or– Receive $10,000 in four years.

• If you are like most people, you would choose to receive the $10,000 now.

• It makes little sense to defer (delay) a cash flow into the future when you could have the exact same amount of money now.

Time Value of Money• From an investment perspective, those in business

know you can do much more with money if you have it now because you can earn even more money through wise investments.

• The value of the money that is invested now at a given rate of interest and grows over time is called the future value of money. The process of money earning interest and growing to a future value is called compounding.

• See Go Figure! for an illustration of this.

go figure!

To see why this is so, consider Rhonda and Ron. Both are owed $1,000. Rhonda collects the money owed to her on January 1st while Ron collects the $1,000 owed to him on December 31st of the same year. After thoroughly evaluating her investment opportunities, Rhonda takes her money on January 1st and invests it in a company that will pay her a 10% annual rate of return. As a result, on December 31st Rhonda would have $1,100 as shown using the total investment value formula as follows:

Investment + Return on Investment = Total Investment Value

or

$1,000 + ($1,000 X 0.10) = $1,100 As a result of her investment, at the end of the year, Rhonda’s $1000 is now worth $1,100, while Ron’s $1000 is, of course, still worth only $1,000. Now, assume that Rhonda elects to re-invest her original $1,000 and all of her investment earnings. If she does so, Rhonda is poised to increase the future value of her money even further by earning investment returns over an even longer period of time. The value of the money that is invested now at a given rate of interest and grows over time is called the future value of money. The process of money earning interest and growing to a future value is called compounding. If Rhonda maintained her investment for four years, it would grow as follows: Year 1 $1,000 + ($1,000 X 0.10) = $1,100 Year 2 $1,100 + ($1,100 X 0.10) = $1,210 Year 3 $1,210 + ($1,210 X 0.10) = $1,331 Year 4 $1,331 + ($1,331 X 0.10) = $1,464

go figure!

The formula managerial accountants use to quickly compute the future value of an investment when the rate of return and length of the investment is known is as follows:

Future Value = Investment Amount X (1 + Investment Earnings %)n

or

FVn = PV x (1+i)n Where FV equals the amount of the investment at the end of the investment period (future value), PV equals the present value of the investment, n equals the number of years the investment will be maintained, and i equals the interest rate %. In the example of Rhonda’s four-year investment, the future value formula would be computed as:

$1,000 X (1 + 0.10)4 = Future Value

or

$1,000 X (1.464) = $1,464

Time Value of Money

• The effect of a compound investment earning 10% annual returns is summarized below.

Figure 12.2 Effect of Compound Investment Returns

Value Year 1 Year 2 Year 3 Year 4

Beginning Value $1,000 $1,100 $1,210 $1,331

Investment Earnings 100 110 121 133

Year End Total Investment Value $1,100 $1,210 $1,331 $1,464

Time Value of Money

• When a future value is known, then the present value, or the amount the future value of money is worth today, can be determined.

• The process of computing a present value is called discounting, or calculating the value of future money discounted to today’s actual value.

• See Go Figure! for an illustration of this.

(go figure! continued)

When a future value is known, then the present value, or the amount the future value of money is worth today, can be determined. The process of computing a present value is called discounting, or calculating the value of future money discounted to today’s actual value. The formula managerial accountants use to quickly compute the present value of an investment when the rate of return and length of the investment is known is as follows: Present Value = Future Value (1 + Investment Earnings %)n or PV = FVn (1 + i)n Where FV equals the amount of the investment at the end of the investment period (future value), PV equals the present value of the investment, n equals the number of years the investment will be maintained, and i equals the interest rate %. In the example of Rhonda’s four-year investment, the present value formula would be computed as: $1,464 (1 + 0.10)4 = Present Value or $1,464 1.464 = $1,000 Put another way, Rhonda’s $1,464 investment (received four years from now) would be worth $1,000 today.

Time Value of Money

• Future values and present values can be calculated using the formulas stated in this chapter, time value of money tables, and/or financial calculators.

• As you (and all savvy investors) now recognize, maximum returns on money invested (ROI) are achieved by utilizing one or both of the following investment strategies:1. Increasing the length of time money is invested2. Increasing the annual rate of return on the investment

Rates of Return

• Before closely examining rates of return, it is very important for those in the hospitality industry (as well as all other industries!) to understand that operating profits are not the same as return on investment.

• Sometimes, a restaurant that achieves a very good profit (net income) is still not a good investment for the restaurant’s owner.

• In other cases, a restaurant that achieves a less spectacular net income is a better investment.

• See Go Figure! for an illustration of this.

go figure!

For example, assume two restaurant owners have generated $200,000 in net income after a year of operating their respective restaurants. The first owner invested $2,000,000 in the operation, and the second owner invested $4,000,000. Using the ROI formula you learned about in Chapter 3, the owners’ ROIs can be calculated as follows:

Money Earned on Funds Invested Funds Invested = ROI or First Owner: $200,000 $2,000,000 = 10% Second Owner: $200,000 $4,000,000 = 5%

Rates of Return• Actual returns on investment can vary greatly, but few,

if any, investors will for a long period of time invest in a restaurant if the net income is less than what could be achieved in other investment opportunities with the same or lesser risks.

• Sophisticated managerial accountants can utilize several variations of the basic ROI formula to help them make good decisions about investing their capital.

• For working managers interested in maximizing returns on investment, two of the most important of these formula variations are:– Savings Rate of Return– Payback Period

Savings Rate of Return• The savings rate of return is the relationship between

the annual savings achieved by an investment and the initial capital invested.

• An example of this information based on Amy Sussums, a country club manager who is contemplating the purchase of a new dish machine, is presented in Figure 12.4 and the following Go Figure! exercise.

• In many cases, managerial accountants and/or the owners of a business will set an investment return threshold (minimum rate of return) that must be achieved prior to the approval of a capital expenditure.

Figure 12.4 Country Club Dish Machine Cost Analysis Current Dish Machine Proposed New Dish Machine

Book Value = $8,000 Cost is $22,000 installed

Expected machine life is three years Expected machine life is fifteen years

Current value (if sold) is $3,000 Value (if sold) in 15 years is $ 0.

Annual operating costs are $ 41,200 Annual operating costs are $31,000 due to the machines fewer labor hours required and increased energy efficiency

go figure!

Based on the information Amy has gathered:

The new machine costs $22,000 (installed) and the value of the old machine is $3,000.

Thus, the new capital required to be invested in the machine would be $19,000 ($22,000 - $3,000 = $19,000).

Amy will achieve cost savings of $10,200 per year ($41,200 to operate the old machine - $31,000 to operate the new machine = $10,200 annual savings).

She can compute her savings rate of return as follows: Annual Savings Capital Investment = Savings Rate of Return or $10,200 $19,000 = 53.7%

Payback Period

• Payback period refers to the length of time it will take to recover 100% of an amount invested.

• Typically, the shorter the time period required to recover all of the investment amount, the more desirable it is.

• Managerial accountants often utilize the payback period formula to evaluate different investment alternatives.

• See Go Figure! for an illustration of this.

go figure!

In the dish machine example cited in Figure 12.4, Amy would compute her payback period as: Capital Investment Annual Income (or Savings) = Payback Period or $19,000 $10,200 = 1.86 years (approximately 1 year and 10 months)

Capitalization Rates

• In most cases, business investors are not guaranteed a return on their investments.

• Investment returns typically increase as an investment’s risk level increases.

• To fully appreciate how business investors estimate their ROIs and then consider risk levels, you must first understand capitalization rates.

• In the hospitality industry, capitalization (cap) rates are utilized to compare the price of entering a business (the investment) with the anticipated, but not guaranteed, returns from that investment (net operating income).

Capitalization Rates

• This ties investment returns to:– The size of the profits (net operating income) generated

by the business– The size of the investment in the business

• Net operating income (NOI), in general, is the income before interest and taxes you would find on a restaurant or hotel income statement.

• Investors generally do not want to pay more than the true value of any specific hospitality business or property they are considering purchasing.

• See Go Figure! for an illustration of this.

go figure!

To illustrate, consider the High Hills Hotel, which was offered for sale for $16,000,000. The hotel’s net operating income for the past annual accounting period was $2,000,000. The cap rate % formula can be restated using the property value as the investment amount. The computation of the cap rate in this example would be: Net Operating Income Property Value = Cap Rate % or $2,000,000 $16,000,000 = 12.5%

Conversely, the property value estimate is calculated as follows: Net Operating Income Cap Rate % = Property Value Estimate or $2,000,000 12.5% = $16,000,000

Capitalization Rates

• Cap rates that are higher tend to indicate a business is creating very favorable net operating incomes relative to the business’s value (selling price).

• Cap rates that are lower indicate that the business is generating a smaller level of net operating income relative to the business’s estimated value (selling price).

• In general, cap rates are used to indicate the rate of return investors expect to achieve on a known level of investment.

Financing Alternatives

• For investors, financing simply refers to the method of securing (funding) the money needed to invest.

• Theoretically, financing alternatives for a purchase could range from paying cash for the full purchase price (100% equity financing) to borrowing the full purchase price (100% debt financing).

• Because investments are typically financed with debt and/or equity funds, the precise manner in which financing is secured will have a major impact on the return on investment (ROI) investors ultimately achieve.

Debt versus Equity Financing• With debt financing, the investor borrows money and

must pay it back with interest within a certain timeframe.

• With equity financing, investors raise money by selling a portion of ownership in the company.

• Common suppliers of debt financing include banks, finance companies, credit unions, credit card companies, and private corporations.

• Equity financing typically means taking on investors and being accountable to them.

• ROI on equity funds is achieved only after those who have supplied debt funding have earned their own ROIs.

Debt versus Equity Financing• Equity investors typically are entitled to a share of the

business’s profits as long as they hold, or maintain, their investments.

• The amount of ROI generated by an investment is greatly affected by the ratio of debt to equity financing in that investment.

• The debt to equity ratio in an investment will also affect the willingness of lenders to supply investment capital.

• Figure 12.6 illustrates the affect on equity ROI of funding the investment with varying levels of debt and equity.

Figure 12.6 Effect of Debt on Equity Returns

Financing Project Cost Payment or

Return % Net Operating

Income

Debt Coverage

Ratio 27,000,000 5,145,123 Debt 50% - 13,500,000 Interest Payment 8.0% - 1,080,000 4.8 Equity 50% 13,500,000 ROI 30.1% 4,065,123 27,000,000 5,145,123 Debt 60% - 16,200,000 Interest Payment 8.0% - 1,296,000 4.0 Equity 40% 10,800,000 ROI 35.6% 3,849,123 27,000,000 5,145,123 Debt 70% - 18,900,000 Interest Payment 8.0% - 1,512,000 3.4 Equity 30% 8,100,000 ROI 44.9% 3,633,123 27,000,000 5,145,123 Debt 80% - 21,600,000 Interest Payment 8.0% - 1,728,000 3.0 Equity 20% 5,400,000 ROI 63.3% 3,417,123

Debt versus Equity Financing

• For any investment, the greater the financial leverage or funding supplied by debt, the greater the ROI achieved by the investor.

• “Why not fund nearly 100% of every investment using debt?” The answer to this question lies in the column titled Debt Coverage Ratio.

• This is the same ratio as the Times Interest Earned ratio that you learned about in Chapter 6.

• The debt coverage ratio is a measure of how likely the business is to actually have the funds necessary for loan repayment.

• See Go Figure! which illustrates how to calculate this.

go figure!

The debt coverage ratio can be calculated for 50% debt and 50% equity financing from Figure 12.6 as follows: Net Operating Income Interest Payment = Debt Coverage Ratio or $5,145,123 $1,080,000 = 4.8

Debt versus Equity Financing• Lenders will analyze debt coverage ratios to determine

the risk they are willing to assume when lending to an investor’s project.

• Projects with lower than desirable debt coverage ratios will most often come at a higher cost (interest rate).

• Because of risk, some lenders will provide debt financing for no more than 50 to 70% of a project’s total cost. This creates a loan to value (LTV) ratio, a ratio of the outstanding debt on a property to the market value of that property, of 50- 70%.

• The project’s owners, then, will have to secure the balance of the project’s cost in equity funding.

Lease versus Buy Decisions

• Leasing, (an agreement to lease) allows a business to control and use land, buildings, or equipment without buying them.

• In a lease arrangement, lessors gain immediate income while still maintaining ownership of their property.

• Lessees enjoy limited property rights and distinct financial and tax advantages, as well as the right, in many cases, to buy the property at an agreed upon price at the end of the lease’s term.

• Figure 12.7 details some significant differences between the rights of property owners (lessors) and lessees of that same property.

Figure 12.7 Select Legal Considerations of Buying vs. Leasing Property 1. Right to Use the Property

Owner Lessee Property use is unlimited in any legal manner owner sees fit.

Property use is strictly limited to the terms of the lease.

2. Treatment of Cost Owner Lessee Property is depreciable in accordance with federal and state income tax law.

Lease payments are deductible as a business expense, according to federal and state tax laws.

3. Ability to Finance Owner Lessee The property can be used as collateral to secure a loan.

The property may not generally be used to secure a loan.

4. Termination Owner Lessee Ownership passes to estate holders.

The right to possess the property concludes with the termination of the lease contract.

5. Non-Payment of Lease Owner Lessee Owner retains the down payment and/or foreclose on the property.

Owner retains deposit and/or owner may evict lessee. For personal property, the owner may reclaim the leased item.

Lease versus Buy Decisions

• The most significant financial difference between buying and leasing is that payments for owned property by lessors are not listed as a business expense on the monthly income statement.

• Rather, the value of the asset is depreciated over a period of time appropriate for that specific asset on the balance sheet.

• Payments for most (but not all) leased property by lessees, however, are considered an operating expense and thus are listed on the income statement.

• See Figure 12.8. for advantages of leasing.

Figure 12.8 Advantages of Leasing 1. Low Cost Tax Advantages. One of the most popular reasons for leasing is its low cost. A

lease can offer low cost financing because the lessor takes advantage of tax benefits that are passed to the lessee. If the lessee cannot currently use tax depreciation to offset taxable income due to current operating losses, depreciation benefits may be lost forever if the lessee purchases rather than leases.

2. On or Off Balance Sheet Options. In some cases, a lease can be structured to qualify as an

operating lease, the expense for which is properly reported on the income statement, thus increasing the business’s flexibility in financial reporting and directly affecting important financial ratios such as the operating profit percentage.

3. Improved Return on Investment. Many companies place a heavy emphasis on ROI for

evaluating profitability and performance. Operating leases often have a positive effect on ROI because leasing typically requires less initial capital to secure an asset than does purchasing.

4. 100% Financing. In many cases, leasing may allow the entire cost of securing an asset to be

financed, while a typical purchase loan requires an initial down payment. Most costs incurred in acquiring equipment can be financed by the lease. These costs include delivery charges, interest charges on advance payments, sales or use taxes, and installation costs. Such costs are not usually financed under alternative methods of equipment financing.

5. Budget Expansion. The acquisition of equipment not included in a capital expenditure

budget can sometimes be accomplished through use of a lease, with lease payments being classified as monthly operating expenses.

6. Joint Ventures. Leasing can be ideal for joint venture partnerships in which tax benefits are

not available to one or more of the joint venture partners. This may be because of the way in which the partnership was structured, or because of the tax situation of one or more of the joint venture partners. In such cases, the lessor may utilize the tax benefits, which would otherwise be lost, and pass those benefits to the joint venture in the form of lower lease payments.

7. Improved Cash Flow. Lease payments may provide the lessee with improved cash flow

compared to loan payments. As well, the overall cash flow on a present value basis is often more attractive in a lease.

Lease versus Buy Decisions

• Despite their varied advantages, leases can have distinct disadvantages in some cases including: – Non-ownership of the leased item or property at the end of

the lease.– In situations where few lease options exist, the cost of

leasing may ultimately be higher than the cost of buying.– Changing technology may make leased equipment obsolete,

but the lease term is unexpired.– Significant penalties may be incurred if the lessee seeks to

terminate the lease before its original expiration date.

Taxation

• Managerial accountants who fully understand the very complex tax laws under which their businesses operate can help ensure that the taxes these businesses pay are exactly the amount owed by the business, and no more.

• This is important because when the correct amount of tax is paid, ROIs will be maximized and not wrongfully reduced.

Income Taxes

• Taxing entities such as the federal, state, and local governments generally assess taxes to businesses based upon their own definitions of taxable income.

• It is the job of the tax accountant to ensure that the businesses they advise do not overpay on their taxes.

• Tax avoidance is simply planning business transactions in such a way as to minimize or eliminate taxes owed.

• Tax evasion, on the other hand, is the act of reporting inaccurate financial information or concealing financial information in order to evade taxes by illegal means.

• Tax avoidance is legal and ethical, while tax evasion is not.

Income Taxes• Taxable income is generally defined as gross income

adjusted for various deductions allowable by law. • There are about 2.1 million regular, or “C”

corporations in the United States. • The income tax rates (at the time of this book’s

publication) for C corporations are shown in Figure 12.9.

• It is important to understand that all business’s net income is taxed at the federal level, but it most often also is taxed at the state and even local levels.

Figure 12.9 Federal Corporate Income Tax Rates

Taxable Income Over

But Not Over Tax rate

$0 50,000 15%

50,000 75,000 25%

75,000 100,000 34%

100,000 335,000 39%

335,000 10,000,000 34%

10,000,000 15,000,000 35%

15,000,000 18,333,333 38%

18,333,333+ 35%

Bina Nusantara University

Taxable Income Rate

Up to Rp 50.000.000,- 10%

Over Rp50.000.000,- but not over Rp 100.000.000,- 15%

Over Rp100.000.000,- 30%

Based on UU No. 17 Tahun 2000:

• Single Rate• 28% for 2009 fiscal year• 25% for 2010 fiscal year

Based on new Tax Law No. 36/2008:

Corporate Income Tax in Indonesia

Capital Gains Taxes

• A capital gain is the surplus that results from the sale of an asset over its original purchase price adjusted for depreciation (asset basis).

• A capital loss occurs when the price of the asset sold is less than the original purchase price adjusted for depreciation.

• Capital gains and losses occur with the sale of real assets, such as property, as well as financial assets, such as stocks and bonds.

• The federal government (and some states) imposes a tax on gains from the sale of assets.

Property Taxes• In addition to income and capital gains taxes, most

hospitality businesses will be responsible for paying property taxes on the property owned by their businesses.

• These assessments are determined through a real estate appraisal, which is an opinion of the value of a property, usually its market value, performed by a licensed appraiser.

• Market value is the price at which an asset would trade in a competitive setting.

Other Hospitality Industry Taxes

• Hospitality businesses are responsible for reporting and paying a variety of hospitality industry taxes.

• Sales Tax. In most cases, sales taxes are collected from guests by hospitality businesses for taxes assessed on the sale of food, beverages, rooms, and other hospitality services. Typically, the funds collected are then transferred (forwarded) to the appropriate taxing authority on a monthly or quarterly basis.

Other Hospitality Industry Taxes

• Occupancy (Bed) Tax. Occupancy (bed) taxes are a special assessment collected from guests and paid to a local taxing authority based upon the amount of revenue a hotel achieves when selling its guest rooms.

• Tipped Employee Tax. Tipped employee taxes are assessed on tips and gratuities given to employees by guests or the business as taxable income for those employees. As such, this income must be reported to the IRS, and taxes, if due, must be paid on that income.

Role of Hospitality Managers• While it is not reasonable for most hospitality managers

to become tax experts, it is possible for them to:1. Be aware of the major entities responsible for tax collection

and enforcement.2. Be aware of the specific tax deadlines for which they are

responsible.

3. Stay abreast, to the greatest degree possible, of changes in tax laws that may directly affect their business.

Role of Hospitality Managers

• Directorate General of Tax Office (Ditjen Pajak) is the taxing authority with which hospitality managers are likely most familiar.

• Among other things, Ditjen Pajak requires businesses to do the following:– File quarterly income tax returns and make payments on the

profits earned from business operations.– Withhold income taxes from the wages of all employees and

deposit these with the Ditjen Pajak at regular intervals.

Role of Hospitality Managers• Report all employee income earned as tips and withhold

taxes on the tipped income.• Record the value of meals charged to employees when

the meals are considered a portion of an employee’s income.

• Furnish a record of withheld taxes to all employees on or before January 31 of each year (Form W-2).

• It is the role of hospitality managers to stay abreast of significant changes in tax laws and follow them to the letter.

Review of Learning Outcomes

• Identify the purpose of capital budgeting.• Compute business owners’ investment rates of return.• Identify advantages and disadvantages of capital

financing alternatives such as debt versus equity financing and lease versus buy decisions.

• Determine the effects of taxation on a hospitality business.