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Capital Spending: Treat It Like An Investment, Because It Is

For almost two years now, middle-market business owners and management teams have been challenged by the global economic crisis to make the tough decisions necessary to ensure that they survive, and ultimately thrive, in uncertain economic times. Cash-flow management has been king, and our clients did impressive work to improve operating cash flows including:

• Reducing inventory levels, in some cases dramatically
• Intense monitoring of customer credit limits
• Aggressive follow-up on delinquent A/R
• Requesting extended terms from vendors
• Reducing employee rolls and driving down other expenses
• Delaying capital expenditures

As the economy shows tentative signs of a recovery, and customer demand begins to increase, mid-sized manufacturers are beginning to re-evaluate their strategy for future capital expenditures. While delaying capital expenditures reduces cash outflow in the short term, being ready and able to reinvest in your business in the form of new equipment is oftentimes crucial to a manufacturer’s ability to pursue new business opportunities and profitably grow the company. The key is to allocate resources wisely. Like any investment, capital expenditures should produce future cash flows that recover your initial investment and provide the organization with a return that is acceptable relative to the risk being taken.

When a company makes an acquisition, the purchase price is often based on the net present value of cash flows that the acquired business is expected to generate in the future. Capital spending decisions should be analyzed in a similar way. It is important to consider all the cash flows, positive and negative, when making such decisions. Before making a substantial capital investment, an organization should ask the following questions:

• What is the “all in” cost, including initial cost, freight, installation, and plant downtime (if any)?
• Can used equipment be purchased as opposed to new equipment?
• Will tax advantages offset some of the cost?
• What efficiencies are gained by acquiring this equipment? (Productivity enhancements, better material usage, reduced labor costs, reduced set-up cost, reduced maintenance and downtime, etc.)
• Do we have the expertise in house to operate and maintain the equipment that is being purchased? Will extensive training and staff upgrade be needed?
• Does this equipment enable the company to pursue new customers, new business with existing customers, etc.?

Adequate consideration of questions such as those above will help ensure that you make sound capital expenditure decisions.

Currently, there are a variety of tax incentives available to companies that are making capital investments. Such incentives include the recently passed HIRE Act (Hiring Incentives to Restore Employment Act), which extended favorable depreciation under section 179 of the Internal Revenue Code (IRC) to tax years beginning in 2010. With limited exceptions, a deduction is allowed in 2010 up to $250,000 with an $800,000 phase-out. Thus, an organization with $700,000 in capital spending in 2010 may immediately deduct $250,000 for income tax purposes. The remaining $450,000 will be depreciated under MACRS (the modified accelerated cost recovery system) and other applicable tax depreciation rules, which of course vary for different types of capital assets.

While bonus depreciation incentives have not been extended to 2010, there are bills pending in Congress that include an extension of 50% bonus depreciation.

It is important to realize that the depreciation rules discussed above apply for Federal Tax purposes. While the state of Illinois complies with the $250,000 Section 179 depreciation deduction, Illinois does not follow the Federal Tax rules for bonus depreciation. The depreciation rules vary from state to state, and we will be happy to discuss specific state tax matters with you.

A note about discounted cash-flow computations: When estimating the present value of future cash flows, it may be appropriate to utilize an organization’s Weight Average Cost of Capital (WACC) as a discount rate. This rate is the weighted average of the expected returns on equity capital and debt capital, where the weights are estimated based on the projected long-run capital structure of the company from the market participant’s view. WACC is generally much higher than an organization’s incremental borrowing rate and is generally a more appropriate discount rate as it considers the organization's cost of equity in addition to its cost of debt. Naturally, some capital projects may carry risks that differ from the risk of the organization as a whole. In these circumstances, the discount rate being used should be adjusted accordingly.

As your organization begins to emerge from the recession, targeted and well-planned capital investments can help you enhance your company’s capabilities and grow new business. Naturally, such spending should be approached with a proper level of caution and treated for what it is: a long-term investment in your organization’s future.

For more information on capital spending, please contact Kevin Loudon, Senior Manager, at 312-980-3358 or your Blackman Kallick representative. 

This publication is part of Blackman Kallick’s marketing of professional services, and is not written tax advice directed at the specific facts and circumstances of any person and/or entity. Contents of this publication are of a general nature, and you should not act on this information without obtaining professional advice from your business advisor that is appropriately tailored to your individual needs and circumstances. This written advice is not intended or written to be used, and cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.