Capitalizable expenditures are made to acquire new assets for expansion, to replace or modernize existing fixed assets within the company.
To evaluate capitalizable disbursement alternatives, the after-tax cash inflows and outflows associated with each project must be determined. Cash flows are evaluated, instead of evaluating accounting figures because they are the ones that directly affect the company's ability to pay bills or buy assets.
The accounting figures and cash flows are not necessarily the same because the income statement represents certain expenses that do not represent cash disbursements. When a project purchase is intended to replace an existing asset, the increasing cash inflows and outflows resulting from the investment should be evaluated.
Types of cash flow
The patterns for cash flow related to capitalized disbursement projects can be classified as conventional or unconventional.
Central theme
Capitalizable disbursements are expenditures that generate benefits over a period greater than one year.
Conventional cash flows
The conventional cash flow pattern consists of an initial outlay followed by a series of cash inflows. This rule is related to many kinds of capitalizable outlays, for example, a company can spend a certain amount "X" of money today and anticipate the result of a number "Y" of inflows at the end of each year for a certain number of years.
Unconventional cash flows
An unconventional cash flow pattern is one in which an initial outlay is not followed by a series of entries. As an example, there is the form of alternating entries and exits or an entry followed by several disbursements. A common type of unconventional cash flow pattern results from the purchase of an asset that generates cash inflows for a period of years, is repaired, and again generates a cash flow for several years.
Net investment
The term net investment in this case refers to the relevant cash flow that must be considered when evaluating a capitalized outlay in perspective. It is calculated by totaling all the outputs and inputs that occur at the time of disbursement to obtain the expense.
The basic variables that must be taken into account to determine the net investment related to a project are:
- The cost of the new project Installation costs Returns on the sale of assets Taxes incurred on the sale
Expected benefits on a compounding outlay are calculated as incremental after-tax cash inflows.
The following model is used to determine the net investment:
New project cost
(+) Installation cost
(-) Net profit from the sale of assets
(+) or (-) Taxes on the sale of assets
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Below is an explanation of each of the factors involved in obtaining the net investment.
1. Cost of new projects
The cost of a new project is the necessary expense. Normally the company deals with the acquisition of a fixed asset for which a price is paid, if an existing physical medium is not being replaced and there are no installation costs, the purchase price of the asset is equal to the net investment.
Comment: Each compounding out-of-pocket decision should be analyzed very carefully to ensure that setup costs have not been overlooked.
2. Installation costs
Installation costs are all additional costs incurred by the company to put a machine into operation.
The cost of installing a new machine is considered part of a capitalizable outlay, since at the time of calculating taxes, this cost is part of the depreciable value of the assets.
3. Net profit on the sale of assets
If a new asset is intended to replace an existing asset that is for sale, the net proceeds from the sale are considered as cash income, this profit must be deducted from the net proceeds obtained from the sale.
4. Taxes
Taxes must be taken into account when calculating the net investment, wherever a new asset replaces an old one that has been sold.
The net proceeds from the sale of an asset are taxable. The following cases may occur when carrying out the tax:
- The asset is sold for a higher value than its purchase price The asset is sold for a higher book value but less than the purchase value The asset is sold for its book value The value is sold for less value than books.
In each of the countries the accounting treatment is different for each of these cases, so it is important to investigate these aspects in particular.
