Property, Plant, & Equipment

1. Property, Plant, & Equipment By: John Hanna Justin Byrd

2. Property, Plant, & Equipment • PP&E is a part of generally every company in the country • PP&E is also known as “fixed assets” • Can include assets from office equipment, manufacturing equipment, heavy machinery, and buildings just to name a few

3. What we will cover…. • Overview • Controller’s Role • Capital Budgeting Process • Method of Evaluating Projects (Payback, Accountant’s, Discounted Cash Flow) • Hurdle Rates • Project Risk Analysis • Inflation • Ranking Capital Projects • Post-Project Appraisals • Other Aspects of Fixed Assets

4. PP&E • Planning is critical to long-term health of an organization (Investment, Financial Performance) • Investment issues (Long recovery period, possible bankruptcy) • Break-even point is higher for companies when investing in PP&E (depreciation, insurance, property taxes, maintenance) • Technological advances in today’s society cause companies to continually invest in more PP&E • Increase Productivity • Increased ROI • Analytical Approaches

5. Role of Controller • Financial knowledge is needed to evaluate the acquisition decisions of purchasing new fixed assets. The Controller and his or her team must take appropriate steps to determine the benefit of purchasing new equipment. • Once the CEO and Board of Directors agree to the investment, the Controller must properly account for the asset and measure depreciation as well as performance throughout the asset’s useful life.

6. Role of Controller • Controller’s Tasks for PP&E • Review all requests for probable rate of return • In business plan, include all assets needing to be purchased and determine if sufficient funds are present and the sales number that needs to be met in order to cover purchase • Planning and Control • Lease, Rent, or Buy • Insurance Coverage • Depreciation Policy • Internal Control • Property Records (Location, Transfers, etc) • Reporting System (Maintenance, Idle Time, Cost vs. Budget)

7. Capital Budgeting • Controller should be involved in planning • Provided to the CEO and other senior executives to select certain projects that will be undertaken • Spending must be kept within an established limit • For larger projects, inform management how the assets is operating as well as anticipated earnings • Capital Budget – 9 Steps

8. Capital Budget – 9 Steps • 1.) Planning period, determine spending limits • 2.) Present worthy capital investment projects (ROR, expansion) • 3.) Preliminary screening of proposals • 4.) Once screened, classify new projects by need and benefit • 5.) Review, compatible with resources? Rate of Return? • 6.) Present data to Board of Directors or CEO • 7.) When time to purchase, authorize from management • 8.) Periodic reports, cost to date, cost to completion • 9.) Post-completion audit, actual vs. estimated cash flow

9. Limit of Capital Budget • Top management will set budget, and is determined by setting a maximum amount to spend towards capital expenditures. • Factors include…. • Strategic Plans • Stage of Business Cycle • Current and Anticipated Inflation Rates • Anticipated Competitor Actions • Age and Condition of Present Plant Equipment • Growth Prospects of Company • Capital Structure of Company (Debt to Asset ratio) • Internal Cash Generation/Spending

10. Capital Expenditure Proposals • All decisions to purchase will go to top management • Factors to replace old equipment • Salvage Value of Used Equipment • Investment and Installation Costs • Useful Life of New Asset • Operating Cost • Factors for expansion of facilities • Market New Products • Increase Sales Quantity • New Project’s ROR • Marketing

11. Evaluating Projects • Since companies cannot undertake every capital expenditure, evaluations of analytical data is examined to select the appropriate projects • 1.) Estimate expected capital outlay and estimated future cash flow • 2.) Relate future benefits to cost • 3.) Evaluate Risk and determine vs. the estimated rate of return • Three Methods • Payback Method • Accountant’s Method • Discounted Cash Flow Method

12. Payback Method • Amount of time needed to pay back original investment from product’s cash flows • Advantages • Company is low on cash and can pay back over a short period • Risky investments • Identify profitability, eliminates undesirable projects • Disadvantages • Confuses recovery of investment with profitability • Early liquidity is prominent, rejects longer projects • Useful life is not considered, can discard asset as soon as payback is met

13. Accountant’s Method • Compares earnings vs. outstanding investment instead of initial investment • Based on making available the depreciation recovered from other capital investments instead of charging against original investment

14. Accountant’s Method • Advantages • Easier than Discounted Cash Flow Method • Disadvantages • Depreciation method is critical • Time Value of Money • Rate of Return doesn’t change

15. Discounted Cash Flow Method • Important factor of method is when cash is received and when it can be reinvested • Two methods • IRR (Internal Rate of Return) • NPV (Net Present Value)

16. Discounted Cash Flow Method • IRR Method • Used as a method to determine maximum constant earnings from an asset over its useful life and relate to the breakeven point • Four Steps • Amount and year of investment • Determine cash flow per year after tax • Apply discount factors (2) and find present worth • Calculate with various discount factors until it correlates to original investment

17. Discounted Cash Flow Method • IRR Advantages • Proper allocation to cash flow and time value of investments • Easy with the use of cash to purchase items (Capital vs. expenses) • Financial analysts can compare other projects • Models the cost-of-capital approach • IRR Disadvantages • Difficult and complex • Calculations are not quickly done • Reinvestment = Calculated Rate of Return

18. Discounted Cash Flow Method • NPV Method • Considers time value of money • Difference between two is NPV uses a predetermined rate, which is the rate the company uses to consider taking the risk of the capital investment • To acquire a new product, the total of the PV of cash flow exceeds the proposed investment • A failed attempt to a capital investment is when the NPV is negative

19. Hurdle Rates • Minimum ROR a project should earn to be acceptable • Businesses in different industries and even each line of business within a company can have different hurdle rates • Business risks determine rates in departments as well as ROR in each division will be different • Different business strategies may exist to establish different hurdle rates • Basis of hurdle rate is cost of capital

20. Project Risk Analysis • Important factors for decision-maker to know • Expected rate of return • Probability of receiving expected rate of return • Sensitivity analysis • Range of possible returns • Should include probability of each of the possible returns • When depreciation or other expenses roll off books

21. Project Risk Analysis • Sensitivity Analysis • Mathematical technique where changes may be made to any of the input factors and consequences of a events that take place • Those who estimate the return on investment know that the estimate is dependent on assumptions • Important to estimate how much an error can affect results • Knowing the potential cost and probability of an error occurring allows the controller or analyst focus on most important variables

22. Project Risk Analysis • Hurdle Rate • Minimum rate of return that a capital project should earn before being deemed acceptable • Investments in capital assets should not only recoup costs, they should pass the hurdle rate • Is usually the discount rate used in considering alternative investments • Used in other contexts as well

23. Project Risk Analysis • New Manufacturing Environment • Automation is primary source of expense reduction, but… • Prior to purchase of automation equipment, should look into other options • Rearrange plant floor, more streamline procedures, eliminate non-value added function • Investments becoming more significant • A machine may cost X dollars, but an automated factory may cost 50X dollars • One must decide how best to allocate costs to optimize value • Equipment is becoming increasingly complex, so benefits should be more tangible

24. Inflation • Questions to consider regarding inflation • Should adjustments be made for inflation in cash flows? • Should inflation rates be used for different cost factors? • Should the hurdle rate be adjusted for inflation? • “Using of proper discount rate, depends on whether the benefits and costs are measured in real or nominal terms. To be consistent and free from inflation bias, the cash flows should match with discount rate.”(Kannadhasan)

25. Ranking Capital Projects • Projects should be ranked in order of priority • Should be practically grouped so management can focus on the more important and promising projects • Grouping example: • Absolutely Essential • Highly Necessary • Economically Justified Projects • All Other

26. Ranking Capital Projects • Projects usually ranked by economic return • Information important for ranking and presentation to management • Priority • Rate of Return • Total Cost • Reasons For • Benefits of • Risks Associated with Project

27. Post-Project Appraisals • Despite good analysis of costs and risks, sometimes projects do not meet the expected rate of return • Without appraisal, management is unaware of the causes of problems or that they even exist • Why this shortfall occurred is important for management to ascertain • Shows what steps can be taken to improve investment planning and control • Factors on which to focus • Cash flow, break-even points, and actual vs. estimates of operating expenses

28. Post-Project Appraisals • Advantages of well-planned post-project appraisal • May detect weaknesses in strategic planning that lead to poor decisions • May detect environmental factors that influence business which were not foreseen • Experience can focus attention on basic weaknesses in overall plans, policies, and procedures • Can detect strengths/weaknesses in individual performance • May enable corrections in current projects prior to completion of commitments or expenditures • Project Risk Analysis

29. Other Aspects of Fixed Assets • Working Capital • Increases in working capital may be required to purchase additional inventory and accounts receivable • Decreases may create need for additional investment • Lease vs. Buy • NPV should be used to compare a lease acquisition against a purchase acquisition • Idle Equipment • Controller should inform management about losses from idle equipment and place responsibility • Losses from idle equipment can derive from depreciation, property tax, insurance, and utilities

30. Other Aspects of Fixed Assets • Idle Equipment • Three causes of idle time • Those controllable by production staff • Poor planning; lack of materials, tools, power; machine breakdowns; improper supervision • Those resulting from administrative decisions • Building of additional capacity (short-term idle) until demand builds to match capacity • Those arising from economic causes • Seasonal demand or excess capacity in industry

31. Other Aspects of Fixed Assets • Internal Control Requirements Surrounding Equipment • Identify all fixed assets by affixing serial numbers or bar codes to items • Transfer of equipment between departments only with written approval for security of physical property • Necessary to track both for insurance and depreciation purposes • Prevent equipment from leaving plant without property pass signed by appropriate authority • Perform physical inventory on all fixed assets • Maintain detailed records on each piece of equipment

32. Other Aspects of Fixed Assets • Internal Control Requirements Surrounding Equipment • Review purchase requisitions to ensure small accounts not made to avoid approval of higher authority • Review retirements of fixed assets • Can assets can be used by another department or do they have anotherother use? • Secure bids on sizeable transactions • Provide for proper insurance coverage during construction of equipment and when complete • Review expenses to ensure capital expenditures no treated as expenses

33. Other Aspects of Fixed Assets • Internal Control Requirements Surrounding Equipment • Track the following items for capital projects • Amount authorized • Actual commitments to date • Actual costs incurred to date • Estimated cost to complete • Indicated total cost • Indicated overrun or under run compared to project budget

34. Other Aspects of Fixed Assets • Plant and Equipment Records • Necessary adjunct to effective control • Convenient source of information for planning, control, insurance, and tax purposes • Records should include: • Name of asset, type of equipment, control number, description, size, model, style, serial number, motor number, purchased new or used, date purchased, vendor name, invoice number, purchase order number, location, account number, transfer information, basis, date retired, sold to, scrapped, cost recovered, depreciation information

35. Other Aspects of Fixed Assets • Plant and Equipment in Relation to Taxes • Many cities and states levy real and personal property taxes or enforce franchise taxes based on value • Maintenance of records can be means of satisfying IRS • Plant and property values, through depreciation expense, is important for federal income tax • The burden of proof is on the taxpayer regarding correctness of claimed depreciation • Handout

36. Overview What is Property, Plant, and Equipment? What is the controller’s role in the budgeting, acquisition, and retirement of these assets? What are the most recognized methods to evaluate a capital budget project? How are capital projects ranked? Why should a post-project appraisal be performed? What other issues factor into the capital budgeting process?

37. Work Cited "Beauliey Pleads Guilty to Tax Fraud-CEO of Beaulieu to Step Down from Corporate Position". Department of Homeland Security. September 17, 2009 <http://www.ice.gov/pi/news/newsreleases/articles/070615rome.htm>. Kannadhasan, M. "Effects of Inflation on Capital Budgeting Decisions-An Analytical Study ". Investopedia. September 17, 2009 <http://www.bim.edu/pdf/lead_article/profkannadhasan.pdf>. "Project Risk and Analysis". CFOonthego. September 19, 2009 <http://www.youtube.com/watch?v=bOP-YLkCla8>. "Property, Plant, and Equipment". Investopedia. September 17, 2009 <http://www.investopedia.com/terms/p/ppe.asp Roehl-Anderson, Janice, and Steven Bragg. The Controller's Function-The Work of the Managerial Accountant. Hoboken: Wiley, 2005.