Capital Assets and Financial Analysis (Week

3)
Topics: Overview of PPE/capital assets, depreciation methods, investment valuation

The historical cost principle requires companies to record Property, Plant, and Equipment assets at cost.
Cost consists of all expenditures incurred in acquiring an asset and bringing it to the point of intended
use. This is defined as capital expenditure. It is important to know when to capitalize a cost (as opposed
to expensing it). This decision has a direct and significant impact on current profits.

Cost is recorded either as the actual cash paid in a transaction or as the cash equivalent price paid when
non-cash assets are given up. The cash equivalent price is equal to the fair value of the asset given up or
the fair value of the asset received, whichever is more clearly determinable.

Let’s try some questions:

Fred buys a new truck by paying $15,000 cash and trading in his old truck ($10,000 market value). What
is the cash equivalent price of the truck?

Summer transfers 1,000 shares of Apple Corporation to Pete in exchange for his townhouse. The shares
were originally purchased for $155 but are now trading at $320. What is the cash equivalent price of the
house?

Fair-Value Measurement: IFRS 13 permits businesses to report certain assets and liabilities at fair
market value (as opposed to book value). This is only allowed for items with readily-available market
values on the measurement date, such as short-term investments in stocks.

The cost of an asset = The sum of all the costs incurred to bring the asset
………………………………….. to its intended purposes, net of all discounts

Land
The cost of land includes the following costs paid by the purchaser:

 The purchase price

 The brokerage commission
 The closing costs (ex. survey, legal, registration, title, and transfer fees)
 Any property taxes in arrears
  The cost for grading and clearing the land and demolition of unwanted existing development

Quick example: Juliana purchases one acre of land for $200,000 for her new business, a coffee shop. She
also pays 4% in brokerage commission and $4,000 in transfer taxes. After the purchase is completed, she
will pay $2,000 to clear the land, a $1,000 survey fee, and $2,000 for a new advertising sign. What will
be the book value of the land?

Purchase price of the land: $

Add related costs:
Brokerage commission $
Transfer taxes
Land clearing
Survey fee
Total incidental costs
Total cost of the land $
.

Juliana has capitalized the total land cost, meaning she will debit the asset (land) account for $215,000.
The advertising sign is expensed since it is not a necessary cost to ready the land for use. The cost of
land is not depreciated.

Land Improvements

Land and Land Improvements are kept separate because, unlike Land, Land Improvements are
depreciated. Some common examples of Land Improvements are:

 Lighting  Paving
 Signs  Fences  Landscaping
 Sprinkler system

Land improvements, like many other items in accounting, requires a certain level of professional
judgement. Sometimes, trees and other plants are better classified as Land if they are not expected to
decline in value and don’t need to be depreciated. This is an instance of accountants being required to
use their best judgement since there aren’t clear rules.

Assuming Juliana spends $3,000 on plants expected to last five years in addition to the $2,000 sign on
July 1, 2022, the journal entry for the cash expense is:
Some examples of long-lived assets which are depreciated (like land improvements) are equipment,
furniture, and computers.

Betterment vs Maintenance

Betterment: an improvement to an asset which either improves the quality/functionality of the asset or
extends its useful life. The costs of betterments are capitalized (they increase the book value of the
asset).

Maintenance: regular work done (or other expense incurred) on an asset (can also be referred to as a
repair) which allows the asset to be used as is, with no significant added life. Maintenance and repair
costs are expensed (they do not increase the value of the asset).

Let’s try some questions:

Sheri adds a new extension to her soda bottle filling machine which will now cap the bottles (they were
previously capped manually). This is betterment / maintenance and it should be capitalized /
expensed.

Artie’s car had a broken exhaust, so he purchased a new one online. Since he uses the car for delivering
pizzas, the cost of the car part should be considered betterment / maintenance and it should be
capitalized / expensed.

Will pays $2,200 for insurance on his work truck. This is betterment / maintenance and it should be
capitalized / expensed.

The last two examples, which are expensed, end up reducing net income. Hence, managers may be
motivated to capitalize repairs, especially if their compensation is partly or fully based on profits.

Alternatively, expensing a capital addition incorrectly reduces income. Some managers might be
motivated to do this to reduce taxes. Of course, either act is unethical and probably illegal.

Depreciation
First, let’s make some key points about depreciation:

 Depreciation is not a process of valuation: Businesses do not depreciate assets based on their
market value- depreciation is always based on an asset’s actual cost.
  Depreciation does not mean that businesses set aside cash to replace assets once they are
fully depreciated: A business can choose to have a cash fund for asset replacement, but
depreciation doesn’t measure/report this in any way.

 Depreciation is sometimes related to physical wear and tear: With the exception of land,
physical wear and tear plays a factor in the depreciation rate of many assets (cars, buildings,
equipment).

 Depreciation is sometimes related to obsolescence: Some assets are simply depreciated

because of expected obsolescence (computers). These types of assets may be physically fit for
longer term use, but efficiency can be improved by upgrading regularly.

Measuring depreciation

Depreciation is based on three factors about the asset: cost, estimated useful life, and estimated salvage
value. An asset’s cost minus its salvage value (also called residual value) is called depreciable cost.

Three methods are commonly used in Canada to calculate depreciation: straight-line, units-of-
production, and double-declining-balance.

Straight-Line Method

This is the simplest depreciation method because it allocates an equal amount of depreciation to each
period of asset use. The equation for straight-line depreciation is:

Straight-line depreciation = Cost – Salvage value

Estimated Useful Life in Years

For review, let’s assume the UCW Bookstore uses the straight-line method for its new desktop
computer, purchased on January 1, 2023. The computer cost $900 with a salvage value of $100. It is
expected to last one year and the bookstore makes depreciation entries right before each quarterly
reporting period. What is the quarterly depreciation expense for the computer?

The journal entry to record the quarterly depreciation expense:

Note that the depreciation rate is ¼ (1/number of depreciation periods). We can make a straight-line
depreciation schedule to present the asset (computer) being written down over a one-year time frame:

Asset Depreciation Depreciable Depreciation Accumulated Asset Book

Date Cost Cost Amount Depreciation Value
Rate
1-Jan-23 $900 $900
31-Mar-23 1/4 x $800 = $200 $200 700
30-Jun-23 1/4 x 800 =
30-Sep-23 1/4 x 800 =
31-Dec-23 1/4 x 800 =

Units-of-Production Method

The Units-of-Production Method allocates a fixed amount of depreciation to each unit of output
produced by the asset. The equation for units-of-production depreciation per unit of output is:

Units-of-production = Cost – Salvage value

Depreciation per Unit of Output Estimated Useful Life in units of production

Let’s try another example. On January 1, 2023, the bookstore purchased a used truck for $21,000 (used
for transporting inventory). The bookstore will use this truck for five years at which point it will have a
salvage value of $1,000. The total expected usage is 100,000 kilometers. The units-of-production
depreciation per unit of output is:

The number of kilometers driven each year is shown in the table below. For simplicity’s sake, let’s
prepare this depreciation schedule by years and not quarters:

Asset Depreciation Number of Depreciation Accumulated Asset Book

Date Cost Per Kilometer Kilometers Amount Depreciation Value
1-Jan-23 $21,00 $21,000
0
31-Dec-23 $0.20 x 19,000 = $3,800 $3,800 17,200
31-Dec-24 0.20 x 21,000 =
31-Dec-25 0.20 x 20,000 =
31-Dec-26 0.20 x 23,000 =
31-Dec-27 0.20 x 17,000 =

Double-Declining-Balance Method
The Double-Declining-Balance (DDB) Method computes depreciation by multiplying an asset’s book
value by a constant percentage, two times the straight-line depreciation rate. The DDB rate is computed
as follows:

1. Compute the straight-line depreciation rate per year. As an example, let’s revisit our truck
example. The bookstore expects to use the truck for five years. Therefore, the straight-line
depreciation rate per year is 1/5 or 20%.
2. Multiply the straight-line rate by 2 to get the DDB rate. In our truck example, we go 20% x 2 to
get a DDB rate of 40%.

3. Compute the year’s DDB depreciation. Multiply the asset’s book value (cost less accumulated
depreciation) at the beginning of the year by the DDB rate. Salvage/residual value is ignored
except in the final year. The truck’s first year depreciation is:

DDB depreciation for first-year = Asset book value at the beginning of the period x DDB rate
= $21,000 x 0.40 = $

The same approach is used for all of the following years of truck use, except for the last year. In the last
year, a “plug” figure is used to depreciate the asset down to its salvage/residual value. The formula for
the “plug” number is:

Plug number = Asset book value at the beginning of the final period - Salvage value

Let’s practice the Double-Declining-Balance Method by filling out another depreciation schedule:

Asset DDB Asset Book Depreciation Accumulated Asset Book

Date Cost Rate Value Amount Depreciation Value
1-Jan-23 $21,00 $21,000
0
31-Dec-23 0.40 x $21,000 =
31-Dec-24 0.40 x =
31-Dec-25 0.40 x =
31-Dec-26 0.40 x =
31-Dec-27 0.40 x =

2027 depreciation = $ -$ =$

Now that we are familiar with these three depreciation methods, we can see that a certain method
might be more appropriate for a specific asset. If an asset is consistently productive over time, the
straight-line method would work best. If an asset wears out due to physical wear and tear rather than
obsolescence, the Units-of-Production method is most appropriate. Finally, if an asset is more useful or
productive in its early age, the Double-Declining-Balance Method would work best.
Cash flows

Projected cash flows are commonly used to evaluate projects/investments. As a general rule, managers
want cash inflows to exceed cash outflows, but the timing of cash flows is also an important element.
Note that net income can differ significantly from net cash inflow. As an example, depreciation expense
doesn’t have cash outflow, but reduces net income. Hence, we add back depreciation expense to net
income when conducting cash flow analysis. Here are some examples of cash flows relating to capital
budgeting decisions:

Cash outflows Cash inflows

Initial investment Sale of old equipment

Repairs and Maintenance Increased cash received from customers
Increased operating costs Reduced cash outflows from operating costs
Overhaul of equipment Salvage value of equipment

Some questions a firm must ask when making capital budgeting decisions:

 Do we have sufficient funds and resources (qualified personnel, equipment, etc) available to
proceed with this opportunity?

 Are the proposed projects related to each other or are they independent? Does the acceptance
or rejection of one project depend on the acceptance or rejection of another?

 How does the firm want to make capital budgeting decisions? Is it a simple accept/reject
approach or ranking of projects?

 How risky is the project? Are the projected returns relatively certain or dependent on many
factors over a lengthy time period?

Let’s think about these questions as we look at an example involving the UCW Bookstore. The bookstore
has an opportunity to purchase and install self-checkout machines. This will reduce reliance on cashiers
and reduce lines during busy season. In addition to reduction of operating costs, the bookstore will
benefit from more customers (they will be happier avoiding long lines). Let’s have a look at some
relevant numbers:

Initial investment $150,000

Estimated useful life 10 years

Estimated salvage value 0

Estimated annual cash flows

Increased cash inflows from customers $15,000

 Operating and maintenance costs ($5,000)

Reduction in cashier wages $10,000

Net annual cash flow $20,000

The cash payback period is the time period required to recover an investment’s capital cost from the net
annual cash flow produced by the investment.

Cash payback period = Cost of Capital Investment

Net annual cash flow

Let’s calculate the cash payback period for the bookstore:

What if the net annual cashflows were unequal? Assume the bookstore’s self-checkouts will take some
time to catch on. Hence, net cash inflow will be only $2,000 in year one. However, the annual cash flow
from this project will double each year until year five then level off. Let’s calculate the payback period
using a table:

Year Investment Net Annual Cash Flow Cumulative Net Cash Flow
0 $150,000
1 $2,000 $2,000
2
3
4
5
6
7
8
9
10

Note that we reach $150,000 somewhere between the seventh and eighth year. Since the eighth-year
number is closer to our capital cost (and the two years have even cash flows), we can roughly estimate a
cash payback period of 7.75 years.

The net present value (NPV) method comparing two values:

 1) The capital outlay required by an investment
2) The discounted value of cash flows to present day

The difference between these two values is referred to as net present value (NPV). The rate used to
discount the cash flows back to the present is called the discount rate or required rate of return.

Let’s illustrate this concept using an illustration:

To move numbers to the present day, we use this formula:

PV = FV
(1+r)n
Where:

PV = Present Value
FV = Future Value
r = discount rate
n = number of periods

Let’s try using this formula to discount some amounts to the present:

a) a $1,000 payment due one year from now at a discount rate of 5%:
b) $10,000 zero-coupon bond expires two years from now at a discount rate of 4.20%:

c) $55 of interest is owed to you 3.5 months from now at a discount rate of 3.25%:

d) a $200 amount owed to you thirty days from now at a discount rate of 6.50%:

Note that n and r are both expressed in annual terms. Hence, we have to convert days and months to
yearly numbers to perform the calculation.

Let’s try an investment question which requires NPV analysis. We can invest $15,000 into a project
which can be sold for $20,000 three years from now. Assuming a discount rate of 4.50%, should we
invest?

Since a proposal is acceptable with a positive NPV, we should __________________.

Let’s try a more complicated example. Your friend has offered to pay you $1,000 in one year, $2,000 in
two years, and $4,000 in three years in exchange for a $6,000 loan today. Assuming a discount rate of
7%, should you accept this deal?
One more: A project requires a $10,000 investment today and $5,000 in one year. The project will return
$4,000 every six months for two years. Assuming a discount rate of 8%, should we start the project?

Let’s take things a step further. When comparing two projects, should we only think about NPV?

Of course not! Let’s have a look at these 10-year options for our firm:

Project A Project B
Initial investment $40,000 $90,000
Net annual cash inflow $10,000 $19,000
Salvage value $5,000 $5,000
Required Rate of Return 12% 12%

Note that we can discount steady annual cash flows at once using a discount factor. In this case, the
discount factor for 10 years of annual cash flows at 12% is 5.65022.

First, let’s calculate the NPV of both projects:

Project A Project B

We see that Project B has a higher NPV so perhaps we should select it over Project A. However, note the
capital requirements of the two projects- B is over twice as much as A!

Profitability Index = Present Value of Net Cash Flows

Initial Investment
As we see above, the profitability index takes initial investment into account. Let’s try this calculation for
both projects:

Project A Project B
In this case, the profitability index of Project A exceeds that of Project B. Thus, Project A is more
desirable. To use the profitability index accurately, the projects need to be mutually exclusive and the
firm must have limited resources. If not, the firm should invest in both projects, since they both have
positive NPVs.