7 Capital Assets
Media companies have both big and small assets that contribute to the successful operation of the venture. Capital assets are the “biggies” that typically cost a lot, such as buildings and transmitters, and as a result, are regarded as a special financial category. Our authors look at the promises and pitfalls surrounding these expensive, long-term business investments. Dr. Ron Rizzuto is Professor of Finance, the Daniels College of Business, University of Denver. Leslie Hartmann, who also contributed Chapter 2, is Regional Director of Business Analysis for Entercom Communications.
Introduction
In previous chapters, you learned about expense items typical to a broadcast and cable operation. These items, as discussed in Chapter 3, are part of the operating expense section in the “Statement of Profit and Loss.” We also touched on depreciation and amortization expense, as they relate to long-term assets that are displayed on a balance sheet, otherwise known as the “Statement of Financial Position.” This chapter provides an in-depth focus on the long-term assets, specifically capital assets. It defines these assets, gives the reader specific examples of typical assets that fall within these categories, and addresses how these items are budgeted and acquired. In addition, it provides an overview of how these items are expensed or depleted through depreciation, retirement, and impairment. And finally, it addresses various measures of control that companies utilize from both an expense and security side.
Defining Long-term Assets
An asset has been defined as an item of economic value owned by the company or station. Current assets are those that are easily convertible to cash and are expected to be collected or consumed within a 12-month period; they include items such as cash, accounts receivable, and prepaid expenses or inventory. Long-term assets also have an economic value, but they are usually not easily converted to cash and have a life that exceeds a 12-month period. Capital assets, deferred assets, and intangibles are all components in the long-term-asset section of a balance sheet.
Capital Assets
Capital assets consist of tangible property—that is, property that can be seen or touched. Also sometimes referred to as “fixed assets,” this category includes such items as property, equipment, and real estate. The broadcast and cable industries require large capital expenditures to maintain operations and remain competitive with up-to-date technology.
Most companies have policies regarding the dollar amount spent on an item in order to be classified as “capital.” These lower limits may be as low as $500 and as high as $2,500, depending on the company’s size and materiality thresholds. This is due primarily to the cost of tracking capital assets. For example, a calculator may well have a life in excess of five years, but it may cost as little as $20. The internal cost of capitalizing this item, determining and recording depreciation expense, and maintaining the item in inventory would simply not be cost effective. These smaller items are sometimes referred to as “custodial property,” and are typically expensed in the period purchased.
There are major capital expenditures that relate to most industries. These include financial and ERP (enterprise resource planning) systems, discussed earlier in this book, and office facilities, such as a building or leasehold improvements.
The major items unique to radio and TV stations are purchases of transmission equipment, towers, studio equipment, satellite receivers, and remote broadcast vehicles. High definition technology for both radio and TV created the need to replace all analog transmission equipment with a digital delivery system, a very costly venture with an unidentifiable return.
The major capital expenditure items for a cable television operator are customer premise equipment (converters, cable modems, and telephone gateway equipment), headend and hub equipment, fiber-optic and coaxial cable, plant electronics (amplifiers and powering equipment), telephone switches, and advertising-insertion gear for multiple channels.
The major capital expenditures for a cable programmer are studio, cameras and editing gear, satellite equipment, and the video library.
Differentiating Capital Assets
Differentiating capital assets from repairs, custodial, or even current assets is often confusing. Some companies have had to correct their financial systems for unintentional misclassifications. As mentioned earlier, developing and maintaining a consistent policy is the best protection for avoiding such problems. Three examples are cited below:
• Repairs, which are expensed, are sometimes inadvertently treated as a capital improvement. Some examples of this would be a tube used in a transmitter or replacing cable lines. Although these items may meet the threshold for capitalizing, they may not actually increase the long-term value of the asset.
• Another area of distinction is when and how the items are purchased. For example, a chair may cost $250. On its own, it may be categorized as a custodial asset instead of a capital asset. But purchased as part of a set of ten chairs, the cost would be $2,500; hence the larger bulk purchase would be classified as a capital asset.
• A station may decide to give away a vehicle as part of an on-air promotion. Although the vehicle falls within the dollar amount of a capital asset, and may have a useful life of five years, if it is to be given away within the next 12 months, the economic life of the vehicle to the ongoing operation of the station is extremely limited. As a result, the vehicle would remain as a current asset, and be expensed over the duration of the promotion, or when given away.
Depreciating Capital Assets
In the case of a large capital project that spans several accounting periods before completion, the company will utilize a CIP (construction in progress) account until the project is finished and in service. Once an asset is placed in service, companies typically use a fixed asset software system to book the asset, and its “life” officially begins. The fixed asset software is used to track the assets, calculate depreciation, and populate the subsidiary ledger. Although many methods of depreciation are used for tax purposes (refer to Chapter 15), most companies utilize a straight-line depreciation method for bookkeeping and financial reporting purposes. The life (in years) is determined by the number of years that the asset is expected to have economic value. Most companies use a predetermined number of years, standardized for the various fixed asset categories, as identified above. These anticipated life spans are reviewed and updated based on technological changes. Once the life span for an asset is determined, the total cost of the asset, including installation and sales taxes, is divided evenly over the designated number of months, resulting in the monthly depreciation expense. The company will continue recording the depreciation expense until the value of the asset is fully depleted, or until retirement or impairment of the asset.
Asset Retirement or Impairment
When an item is replaced, an important decision is what to do with the replaced item. If the replaced item is of no practical use to the location, it may be abandoned, disposed of, or sold. These are examples of retirement, and each has differing tax consequences (see Chapter 15 for more on this topic). Some companies may choose to relocate or transfer the asset for use at another market. In any of these circumstances, the asset should be removed from the asset list to accurately reflect the company’s current assets, and to avoid paying personal property taxes on the item. If the asset is sold, the sales proceeds—less any remaining value on the asset—are recorded as a gain or loss on the sale, depending on whether or not the sales price exceeds the current value. If the asset is retired or abandoned, any remaining value on the asset gets written off.
The asset list should be monitored periodically to identify obsolescence and assure that retired assets are both properly identified and properly depreciated on financial records. An impairment results when an item no longer has an economic value or its value has declined below the depreciated value. When impairment occurs, the asset must be written down and expensed on the books to reflect the reduced value; this may create a difference between the book and the tax value.
Expense Controls
One of the greatest challenges for the engineer is determining when to take advantage of new technology by purchasing new equipment. The engineer’s primary responsibility is keeping the station, cable television system, or cable programming network up and running, so reliability is a major challenge. The decision-making process becomes a balancing act between becoming outdated with old but reliable technology versus jumping in early with new but untried technology that may prove unreliable. Moving too quickly to a new technology can be costly; sometimes new technology has not been well tested in the field, which can result in bugs or system failures. Technology advances quickly. Sometimes the decision to wait a little while results in significant price savings because prices typically come down when more competing product brands enter the market.
As mentioned in Chapter 5, large entities with multiple stations, systems, or programming networks leverage their size to reduce costs on capital expenditures. Often companies negotiate corporate discounts with particular vendors. Another expensesaving technique is to obtain even greater discounts through bulk purchases, such as buying many computers at one time. Controls for these capital expenditures should be similar to those applied to other purchases, such as vendor review and price quotes. Sometimes companies are more diligent in procuring capital assets because of the size, cost, and long-term outlook of these acquisitions. Additional controls include a capital purchase request form, which may supplement or replace a purchase order. Appropriate management approvals and review from higher levels of management are necessary.
One of the best expense controls is proper tracking and documentation of expenditures. Many companies document capital expenditures through a monthly or quarterly recap to track money spent to date and future purchase requirements. Some companies utilize bar codes for security and inventory purpose. Backup is maintained when items are capitalized to validate the capitalizable amount for the entire life of the asset, usually until retired.
Budgeting and Capital Planning
Capital budgets typically are done for each market or division. The engineer usually prepares studio and transmitter needs because of his or her expertise in these areas. Other department managers turn in annual request forms for their needs and general “wish list.” If there is an IT manager, he or she will manage the division’s computer hardware purchases. The division manager assesses all of the needs in the market and prioritizes first within the division. These budget requests are then consolidated company-wide, and provide a tool to review overall corporate needs and to set priorities based on factors such as urgency and ultimate return on investment. This reduces the need to constantly reassess and prioritize during the year. Because the number of homes to be passed by the cable plant has a direct impact on subscriber revenues, the cable system capital budget should be prepared before the cable system operating budget. Capital purchases for radio and TV stations may also impact revenue, albeit in a minor way.
Decisions about capital items may also impact the operating expense budgets for radio, TV, and cable. This is because items not approved for purchase may still be required for day-to-day use, and must be leased or rented. An example may be the requirement of a T1 line used in place of satellite receiving equipment. Other instances where capital expenditures may reduce operational expenses are in reduction of maintenance and repair costs on newer equipment, such as vehicles, transmitter, and studio equipment.
Different calculations are used to justify the purchase of capital items, as noted below. Typical ROI (return on investment) calculations include reduction of expenses or improved efficiency, such as improved sales productivity, enhancing sales opportunities, or the reduction in personnel.
Although capital assets are put on the balance sheet, and not immediately expensed to the operation’s profit and loss statement, the purchase of capital assets requires the use of cash or borrowed money, and therefore the purchase can have a negative impact on an operation’s cash flow. The ultimate control of the capital budget lies in the resources available to invest.
To evaluate such business proposals as marketing promotions, customer service improvements, training initiatives, new products/services, line extensions, acquisitions, plant upgrades, and the launching of new lines of business, it is imperative that one analyze the financial implications of these proposals.
There are three basic financial analytical frameworks for analyzing a business proposition:
1. Breakeven analysis
2. Payback analysis
3. Discounted cash flow analysis: net present value (NPV) and internal rate of return (IRR)
Each of these techniques will be discussed in more detail. Each method differs with respect to its level of analytical sophistication. Breakeven is the simplest of the methods, whereas discounted cash flow is the most sophisticated.
Anyone working in the electronic media industry should be familiar with all of these methods. For smaller, less-complex projects, a simple breakeven analysis may be sufficient. For more-complicated, less-expensive investments, payback analysis may be acceptable. However, for large long-term capital investments, an analyst will need to draw on the analytical horsepower of the discounted cash flow methods.
Breakeven Analysis
Breakeven analysis is an analytical method that focuses on the relationship between costs and profits at various levels of output. As the name implies, the technique is particularly focused on the output threshold required to generate zero profit or loss.
Knowing the breakeven profit level is useful to decision makers because it provides insight as to the likely economic feasibility of a project. That is, if the breakeven level of output is beyond the realm of possibility, then the decision maker knows that (a) the project is not feasible, or (b) the project will require a significant reconfiguration in costs/pricing in order for it to become feasible. In contrast, if the breakeven output is realistic, the decision maker knows the project/project design is reasonable, and the firm can proceed further with the project.
As the discussion above implies, breakeven analysis is not a technique that provides decision makers with a “go/no-go” decision rule. This technique simply identifies the actual hurdle that the project must surpass in order to be a viable investment. Once decision makers know this important benchmark value, they can use their expertise to determine if the breakeven value is attainable. It provides a “reasonableness test” for the decision maker, who then has to evaluate whether it is likely the company will achieve this level of response from the project.
Breakeven analysis can be applied to many different investment situations (e.g., promotions, new business opportunities, cost-saving situations, etc.). However, this technique is most effective under the following conditions:
1. There is one product.
2. There is one price for that product.
3. There is one variable cost (one variable cost driver).
4. All the variable costs are a function of output.
For example, assume a small cable company is evaluating whether to rent or buy a camera to meet its obligation to televise four local city council meetings annually. The company can rent the camera for $500 per meeting or buy a camera for $1,500. In this example, the camera is the “one product”; the “one purchase price” is $1,500; the “one variable cost” is the $500 rental fee that is driven by usage, and this fee is a function of output—that is, coverage of the city council meeting.
If one or more of these four conditions are not present, the investment decision maker will find that breakeven analysis does not have sufficient “analytical horsepower.” In these situations, decision makers must upgrade their analytical methods to payback or discounted cash flow analysis.
Payback Analysis
Payback analysis focuses on the time frame required to recover the investment in the project. It is similar to breakeven analysis because it focuses on recovery of one’s investment. However, payback differs from breakeven in the following ways:
1. Payback focuses on the length of time needed to recoup the investment, rather than on the output or revenue needed to recover up-front costs.
2. Payback is a projection- or forecast-based technique in that the decision maker has to make some assumptions regarding output or revenue in order to determine payback. Conversely, breakeven analysis solves for output or revenue.
3. Payback is flexible enough to handle multiproduct, multiprice, and multivariable cost-driver situations because it “dollarizes”1 all of these factors. Breakeven, as noted above, cannot accommodate this level of complexity.
4. Payback analysis provides the decision maker with a “decision rule” (i.e., accept the project if the project payback is less than the corporate payback standard). Breakeven analysis provides a benchmark to focus on, rather than a decision rule.
A project’s payback period is simply the length of time required to recover the initial investment. If a project generates equal annual cash flows,2 the payback period is computed as follows:
Annual Cash Flow
In order to make decisions with a payback analysis, decision makers must establish a “corporate standard” for investments. The standard is typically based on: (a) the experience of decision makers with respect to what has been successful in the past, and/or (b) the cutoff point after which, when projects are ranked from shortest to longest payback period, the capital available to fund investments is exhausted. Investments that have paybacks shorter than the “corporate standard” get funded as long as there is sufficient capital available. Those projects that have payback periods longer than the corporate standard get deferred.
Payback analysis provides more versatility than does breakeven analysis. However, it has limitations. These include:
1. The payback period ignores all benefits beyond that period.
2. As a consequence of ignoring benefits beyond the payback period, this analytical method biases capital spending in favor of projects that achieve short-term profitability. Good long-term investments are difficult to justify when one uses payback criteria.
3. The “corporate standard” is a subjective measure. As a consequence, it is difficult to know when the standard needs to be updated because the experience on which it is based is no longer valid.
The limitations of payback analysis have made it necessary for decision makers to find more-sophisticated analytical tools such as the discounted cash flow methods: net present value (NPV) and internal rate of return (IRR).
Discounted Cash Flow Methods
Techniques such as NPV, IRR, and modified payback are analytical methods that incorporate directly the timing of cash inflows and outflows into project evaluation. By directly measuring the magnitude of timing of cash flows, these techniques are able to consider all the cash flows generated by the project, and they allow us to adjust the valuation of cash flows based on the time they occur. (The cash flows received earlier in the life of a project are weighted more heavily than those received later.) By directly adjusting for the time value of money, the discounted cash flow methods are able to eliminate the subjective short-term bias inherent in the payback method.
Assume, for example, that a cable operator is evaluating whether to build an extension to provide service to a hotel. In this case, the decision maker knows that the hotel will pay a fixed monthly rate per guest room over the term of a three-year contract. A discounted cash flow analysis will give the earlier payments more weight than those in the final months of the agreement.
NPV and IRR are preferred methods over payback because:
1. They directly consider the value due to the timing of the receipt of cash flows.
2. They eliminate the bias in capital spending against long-term projects.
3. They consider all the costs and benefits of a project.
4. They provide decision rules that are founded in principles of economics rather than on subjective judgment.3
Time Value of Money (TVM)—Background
The NPV and IRR methods are founded on the concept of the time value of money (TVM). Intuitively, this concept is simply the idea that individuals prefer money “sooner rather than later.” Funds received today are more valuable than the same amount of money received in the future. This is because individuals can invest the money today and have the original sum plus interest in the future.
Think of a certificate of deposit (CD) with a 5 percent simple rate of return for a 12-month investment. If you deposit $1,000 today, you will have $1,050 a year from now.
Present Value Analysis
In many TVM problems, rather than solve for the future value, a manager may be interested in the amount one has to invest today in order to achieve a future financial objective. These backward-looking TVM problems are commonly labeled “present value” problems.
The process of determining present value is simply the reciprocal of the future-value problem.
Net Present Value (NPV)
Financial analysts have historically had a preference for analyzing projects on a present value basis. That is, rather than compare which projects provide the highest future value; they prefer to compare the present value of alternative investments. One key reason for this is because it is quicker to calculate present value.4
The net present value (NPV) method discounts the future cash flows at a discount rate,5 and subtracts the cost of the project. Because the investment is already in present value terms, the process of discounting (present valuing) the cash flows allows a comparison of costs and benefits in today’s dollars.
Think of the CD example above. In that case, $1,050 a year from now has a net present value of $1,000—that is, it is worth $1,000 in today’s dollars.
Internal Rate of Return (IRR)
Whereas the NPV method summarizes an investment from the perspective of the increase in wealth that a project provides for the organization, the IRR method focuses on the percentage annual rate of return that the project generates. IRR and NPV are analytical methods that lead to the same accept/reject decisions. The fundamental difference between the methods is that NPV uses a profit metric (i.e., NPV gives “dollars increase in wealth”), whereas IRR provides an annual percentage return on the capital invested.
Using Financial Measures in Making Capital Investment Decisions
The financial analytical techniques discussed above help decision makers understand the financial viability of a project. Clearly, the likely profitability of a capital project is a key factor; however, it is not the only criterion used in making capital investment decisions. Sometimes projects that are not profitable still get funded because of other critical considerations, such as:
1. It is needed to maintain the infrastructure of the business (e.g., the building’s roof needs to be replaced).
2. It is needed to meet a competitive threat (e.g., a competitor is expanding its channel capacity so as to offer more high definition television services, hence we need to make an investment for defensive reasons).
3. It is needed to test the viability of a new idea (e.g., in order to test the market viability of on-demand advertising, the company may want to experiment with this investment in one market before considering it for the entire corporation).
In Conclusion
Capital investment decisions are business decisions as well as simple finance decisions. Hence, these other factors need to be considered seriously. The financial metrics noted in this chapter, however, provide the framework for decision makers to determine if and when they need to make trade-offs in evaluating capital projects.
Notes
1. Dollarize is used here to reflect a U.S. decision maker. Clearly, the monetary unit of value will vary by country.
2. Payback analysis uses cash flow rather than net income as a measure of benefits. Cash flow is defined as EBITDA (earnings before interest, taxes, depreciation, and amortization) before tax breakeven analysis and EBIT(1–t)+D+A (i.e., earnings after tax but before interest plus depreciation plus amortization).
3. NPV and IRR decision rules are essentially the same decision rules used in microeconomics. Namely, invest if marginal revenue is greater than marginal cost.
4. In order to compare future values, both the initial investment and the project’s cash flows need to be future valued. With present value analysis, only the project’s cash flows have to be discounted, because the investment is already in present value terms.
5. The discount rate, k, is the company’s cost of capital. This is a weighted average cost of the firm’s debt and equity securities used to finance capital projects.