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Diunggah oleh Usman Iftikhar

topic

- quiz 4 solution.pdf
- Capital Budgeting
- NPV
- SW 5 Economic Variability Analysis for Used Tyre
- yosebly06prf
- calicut university energy auditing module 3
- Capital_Budgeting_ani
- Excel Test
- Corporate Finance
- NPV and IRR
- Factory Machine Automation Playbook v12
- 9.1 COURSE ON OF GEOTHERMAL ECONOMIC EVALUATION & MODELING, Gordon Bloomquist, Jeff Ponsness, EnSight and WSU.pdf
- Unit II Project Evaluation
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- Excel Financial Modelling Examples Chapter 1
- 1st LE Formula Summary
- 2nd Finance Prob Solve
- Capital Budgeting Naresh
- Capital Budgeting - Decision Making Practices in Pakistan

Anda di halaman 1dari 66

which long-term investments the company will

make. The process of making these decisions is

called capital budgeting.

The basic method of doing this is:

identify a possible investment opportunity or

project

analyze the relevant cash flows that the

project will generate

apply one or more decision criteria to those

projected cash flows

if the proposed project exceeds the decision

criteria, proceed with the project

The decision criteria that we will look at include;

NPV, IRR, MIRR, payback, discounted payback,

AAR and PI.

K. D. Brewer 2008

Page 4-1

From a finance point of view this is the best of

the decision criteria. The basic idea is that once

we have identified all of the cash flows that are

going to be generated, if we accept a project, we

simply take the present value of those cash

flows. If the total of these discounted cash flows

is positive then the project should increase the

value of the firm. This form of analysis is also

called Discounted Cash Flow valuation (DCF).

The only noticeable problem with NPV is

determining the appropriate discount rate. The

most appropriate discount rate that the firm

should consider is the cost of financing the

investment that is required. If the firm can raise

capital to pay for the investment at 12%, they

should discount the project's cash flows at 12%.

This 12% is called the firm's cost of capital.

K. D. Brewer 2008

Page 4-2

NPV Example

DCF Inc. is considering a capital budgeting

proposal to invest in a small business.

It would cost $50,000 to start this business.

The business is expected to generate $5,000

per year for 5 years.

Five years from now the business can be

sold for $75,000.

DCF's cost of capital for this venture is 15%.

According to the NPV criteria, should DCF invest

in this project?

The PV of the cost is -$50,000.

$5,000 per year for 5 years is an ordinary

annuity with a PV of $16,761

$75,000 5 years from now is worth $37,288

The total is $4,049.

Since the NPV is greater than zero, DCF should

invest in this project.

The project should

increase the value of DCF by $4,049.

K. D. Brewer 2008

Page 4-3

IRR

When talking about investment opportunities,

many people like to talk in terms of rates of

return. IRR, the internal rate of return, finds a

single rate of return to summarize the merits of a

project. To do this, we set up a NPV style

calculation and solve for the discount rate that

sets the NPV equal to zero. If the IRR is greater

than the firm's required rate of return the project

should be accepted.

Since we often have a long series of cash flows

for a single project, we can't easily solve for IRR

directly. Therefore we use a spreadsheet tool or

trial and error, like we did for YTM.

This is the rate of return we would have to make

on a deposit to be able to afford the cash flows

of the project.

Note: if the initial investment is negative, IRR is

a cost of funds not a return on investment.

K. D. Brewer 2008

Page 4-4

IRR Example

Using the previous example, solver

generates an IRR of 17.11%.

This is

higher than DCF's cost of capital of 15% so

IRR suggests that DCF should accept this

investment project since it has a higher

rate of return than their cost.

IRR=

17.11%

Year

Cash Flow

DCF

(50,000.00)

(50,000.00)

5,000.00

4,269.40

5,000.00

3,645.56

5,000.00

3,112.87

5,000.00

2,658.02

80,000.00

36,314.14

NPV=

(0.00)

and the selling price were added together to give

a net cash flow for the year.

K. D. Brewer 2008

Page 4-5

NPV Profile

When using the trial and error approach to

solving for IRR, we can generate a large number

of NPVs. If we plot those we will get the NPV

profile.

NPV Profile

60,000

50,000

40,000

NPV

30,000

20,000

10,000

(10,000)0%

10%

20%

30%

40%

(20,000)

(30,000)

Discount rate

initial investment of $50,000 and net cash flows

of $10,000 per year for ten years with no

salvage value.

K. D. Brewer 2008

Page 4-6

1. Changing decision criteria: if the initial cash flow

is negative, IRR becomes a cost of funds

instead of a rate of return, therefore you want to

accept a proposal if it's IRR is less than your

cost of capital.

2. Multiple solutions: whenever a project has nonconventional cash flows, there can be more than

one IRR. Non-conventional cash flows are any

time the sign of the net cash flow changes more

than once.

3. Mutually exclusive projects: if accepting one

project means that you can't do another project,

the two projects are mutually exclusive. IRR can

give the wrong decision for two reasons, scale

and the reinvestment assumption.

K. D. Brewer 2008

Page 4-7

Non-conventional Cash

Flows

Blue Sky Mines is considering starting a new

open-pit mine. The start up costs are $5m, the

mine should generate $1m per year for the next

30 years, after that the environmental cleanup

costs are estimated at $6m per year for 5 years.

What is the IRR of this project?

The project has non-conventional cash flows

because the first cash flow is negative, cash

flows are then positive for 30 years before

turning negative again.

If you use solver and start with an initial guess

IRR of 5% or greater, you will find an IRR of

19.57%. If your initial guess is around 1% then

solver will come back with an IRR of 1.26%.

K. D. Brewer 2008

Page 4-8

What Happened?

We can see what is happening if we plot the

NPV profile.

NPV Profile

6

4

NPV

2

0

0%

-2

5%

10%

15%

20%

25%

30%

-4

-6

Discount Rate

Maximum = $4.4m at r = 5.5%

Minimum = -$5m at r = 0% or r infinity

You might notice that if the BSM analyst had

found the IRR of 1.26%, the analyst would

recommend not accepting the project.

K. D. Brewer 2008

Page 4-9

There are a few ways of dealing with nonconventional cash flows.

1. You could assume that the company is going to

set up a reserve to pay for the cleanup costs.

This could either be a lump sum added to the

initial investment or a regular amount every

year, reducing the cash flows. Assume that this

money earns the company's cost of capital and

that the FV is equal to the PV of the cleanup

costs at year 30.

2. Plot the NPV profile and note that the project is

recommended between the two IRRs.

3. Just use the NPV for the company's cost of

capital.

K. D. Brewer 2008

Page 4-10

Mutually Exclusive

Some projects will compete for the same

resources. For example a property development

company owns a plot of land and is evaluating

two proposals. One is to develop the land as a

mall, the other is to build a sub-division on the

property. Obviously only one of the projects can

be accepted. How do you decide which one?

With NPV the choice is obvious, the one with the

higher NPV adds the most value to the

company. With IRR the one with the higher IRR

may not be as good as the lower IRR for

reasons of scale or reinvestment assumptions.

The scale problem is easily demonstrated.

Which one period investment is worth more, a

100% rate of return on $10, or a 30% return on

$1,000? The 100% return gets a profit of $10

while the 30% earns $300, 30 times the return of

the other project!!!

K. D. Brewer 2008

Page 4-11

Reinvestment

Assumption

IRR implicitly assumes that you can reinvest any

early cash flows at the IRR. Therefore you can

use them in present value calculations but not in

future value calculations because the value of

the investment that is earning the IRR changes

over time.

You are trying to choose between two projects,

both cost $1m and have a life of 5 years.

Project A has a net cash flow of $1.3m in year 1

and breaks even in the other years. Project B

breaks even in all years except year 5, which

has a net cash flow of $3m. What are the IRRs?

Which is the better project if your cost of capital

is 15%?

Project A has an IRR of 30% and a NPV of

$130,435. Project B has an IRR of 24.6% and a

NPV of $491,530. Project B is better.

K. D. Brewer 2008

Page 4-12

When talking about investment opportunities,

many people like to talk in terms of rates of

return. IRR is expressed as a rate of return;

NPV is a dollar value.

If you aren't sure of the exact rate of return that

you require on a project, IRR can be used. If

you are entering a new industry or market you

may not know exactly how much it is going to

cost to raise the necessary capital for the

investment.

For conventional investment projects that are

not mutually exclusive, IRR is well behaved and

comes to the same conclusion as NPV. Most

projects fall into that category.

The trial and error needed to find the IRR is

simple to do on a computer.

K. D. Brewer 2008

Page 4-13

MIRR

The modified internal rate of return addresses one

of the problems of IRR. MIRR removes the

implied reinvestment assumption from IRR but

adds the requirement that you know the cost of

capital as you do with NPV.

What MIRR does is to find the discount rate that

sets the initial cost of the project equal to the

present value of the future value of the project's

cash flows, reinvested at the company's cost of

capital.

Each cash flow is future valued to the end of the

project's life at the cost of capital. This future

value is then treated as a lump sum and

compared to the initial investment. You can

them solve for MIRR.

FVCF I 0 1 MIRR

K. D. Brewer 2008

Page 4-14

MIRR Example

Under "reinvestment assumption" we compared

two projects, A and B. Both projects cost $1m,

and last for 5 years. Project A has a cash flow of

$1.3m in one year. Project B has a cash flow of

$3m in five years. All other net cash flows were

zero. The cost of capital was 15%.

Project A's cash flow is future valued to the end

of year 5.

$1.3m x (1 + 0.15) 4 = $2.27m

We then set the present value equal to the initial

investment of $1m and solve for IRR.

$2.27 = $1 x (1 + MIRR) 5

MIRR = 17.8%

Project B's cash flow occurs at the end of year 5

so the IRR of 24.6% calculated earlier is fine.

MIRR comes to the same conclusions as NPV.

K. D. Brewer 2008

Page 4-15

Payback

This simple decision criteria measures how long

a project takes to generate cash flows equal to

the initial investment. If this period is shorter

than an arbitrary value, the project is acceptable.

All cash flows after the payback period are

ignored. A project that costs $50,000 and

generates net cash flows $20,000 per year will

have a payback period of 2.5 years. This

payback period will not change if the project

ends at that point or continues indefinitely.

Payback is easy to understand, doesn't require

forecasting of distant cash flows, and is biased

towards liquidity.

Payback ignores the time value of money, has a

cutoff value that is arbitrary, ignores all cash

flows after the payback period (positive or

negative) and is biased against long term

projects.

K. D. Brewer 2008

Page 4-16

Discounted Payback

This rule discounts the future cash flows before

applying the payback criteria. As such it does

not ignore the time value of money, but all of the

other problems of payback remain.

Consider a project that costs $500 and earns

$200 per year for 4 years. What is the payback

period and discounted payback period if the firm

has a cost of capital of 10%?

Year

0

1

2

3

4

CF

-500

200

200

200

200

net

-500

-300

-100

100

300

DCF

-500

182

165

150

137

net

-500

-318

-153

-3

134

and a discounted payback of 3.02 years (3/137).

Note: A $500 shutdown cost in year 5 wouldn't

affect the payback decision.

K. D. Brewer 2008

Page 4-17

AAR

The average accounting return is another possible

capital budgeting decision criteria. AAR takes

the average net income of the project and

divides that by the average book value of the

project's assets. A project costs $40,000 with no

salvage value that generates a net income of

$5,000 per year for 5 years, has an AAR of 25%

AAR

average NI

5,000

25%

average book value 40,000 2

includes depreciation of the initial investment.

This looks like a rate of return, but it isn't. The

calculation ignores the time value of money. If

the net income was variable, the AAR would not

change.

Also, AAR looks at accounting numbers rather

than cash flows.

K. D. Brewer 2008

Page 4-18

Profitability Index

Also known as the benefit/cost ratio, the PI takes

the present value of the project's cash flows and

divides that by the initial investment. If the

profitability ratio is greater than 1, the project is

acceptable. This is very similar to NPV. NPV

subtracts the initial investment, PI divides by it.

If the initial investment is less than the present

value of the project's cash flows, both NPV and

PI will find the project to be acceptable.

The profitability index (minus 1) can be thought

of as the rate of return in excess of the required

rate of return, similar to the real rate of return

adjustment for inflation. This rate of return can

be used to rank projects on a "bang for the

buck" basis.

Since the PI is a ratio, it has the same problem

with scale as IRR when dealing with mutually

exclusive projects.

K. D. Brewer 2008

Page 4-19

PI Example

DCF Inc. is considering a capital budgeting

proposal to invest in a small business.

It would cost $50,000 to start this business.

The business is expected to generate $5,000

per year for 5 years.

Five years from now the business can be

sold for $75,000.

DCF's cost of capital for this venture is 15%.

What is the profitability index for this project?

$5,000 per year for 5 years is an ordinary

annuity with a PV of $16,761

$75,000 5 years from now is worth $37,288

dividing by $50,000 gives a PI of 1.081

The profitability index is 1.081, which is greater

than one so the project should be accepted. If

we subtract one we can see that DCF would

earn 8.1% above their cost of capital with this

project.

K. D. Brewer 2008

Page 4-20

CB in Practice

So, what is generally used in practice?

The results of a survey of 392 CFOs appears in

table 9.5.

IRR and NPV are used the most, followed by

payback period. Discounted payback and ARR

are still used by a minority, while PI is used by

less than 12%.

Most use multiple methods; NPV, IRR, and

payback add up to over 200%.

Previous editions had an older survey that had a

breakdown by types of project. IRR was used

more often in conventional not mutually

exclusive investment proposals, while NPV

dominated dis-investment proposals and leasing

proposals. No decision criteria was used for

social proposals.

K. D. Brewer 2008

Page 4-21

Multiple Methods

Why would a firm use multiple decision criteria?

Why is payback so widely used?

The answers to these questions are related.

The cash flows of the investment opportunity

are based on estimates of sales or possible

cost reductions.

Sales estimates especially have a tendency

of being overly optimistic.

If several decision criteria recommend the

project it is probably a good idea.

If the criteria disagree, the project should be

examined more closely.

Payback is biased towards liquidity and it is

often used for small projects that can't justify

the cost of a more in depth analysis.

K. D. Brewer 2008

Page 4-22

So far the cash flows relevant to the project

have been clearly specified.

How do we decide which cash flows to include?

The basic rule is that if a cash flow would occur

if the firm does not accept the project, that cash

flow is not relevant to the project. Only changes

in cash flows that occur if the firm accepts the

project should be considered. This is known as

incremental cash flows.

Cash flows can include: new revenue streams

generated by the project (+ve), expenses that

were avoided by accepting the project (+ve),

new expenses caused by the project (-ve), and

any revenues that the firm would have received

if the project was rejected (-ve).

K. D. Brewer 2008

Page 4-23

Sunk Costs

Any cost that has already been incurred and can

not be reversed if the firm chooses not to

proceed with the project is a sunk cost and is not

a relevant cash flow for the project, even if that

cost is directly tied to the project.

An example of this is a market research study

that was commissioned to forecast the cash

flows of the proposed project is a cost that is

going to have to be paid even if the firm decides

not to go ahead with the project.

A sunk cost need not to have been paid before

the start of the project if the liability for that cost

has been incurred and will not be changed by

the project. This can include the allocation of

overhead to the project for cost accounting

purposes where those costs are not affected by

the acceptance of the project.

K. D. Brewer 2008

Page 4-24

Opportunity Costs

If the firm bought a property several years ago

for $20,000 and is now considering a proposal

that would use that piece of land there will be no

cash flow to purchase the land. The land has a

current market value of $35,000. How should

the land be valued for capital budgeting

purposes?

From an accounting stand point, the $20,000

historical cost is what would get charged to the

project for the book value calculations. However

from a finance stand point the $20,000 is a sunk

cost and therefore not a relevant cash flow for

the project.

If the firm does not proceed with the project they

can sell it for $35,000 (less costs). Accepting

the project precludes this possibility. $35,000

(less costs) is referred to as an opportunity cost.

The firm loses the opportunity to sell the land so

this is a lost cash flow.

K. D. Brewer 2008

Page 4-25

Side Effects

ADC Inc. currently has three products with a

combined market share of 60% in a certain

category. A proposed new product in that same

category is forecast to gain a 50% market share.

Obviously some of those sales are going to

come at the expense of ADC's other product

lines. This effect on other cash flows of the

company is referred to as erosion, piracy or

cannibalism. This effect on the other product

lines should be included in the estimates of the

cash flows that are relevant to the proposal.

The side effects of a project don't have to be

negative. If a new product would increase

demand for an existing product, that beneficial

effect should be included.

For example a

company that makes lawn tractors may see

beneficial side effects for adding a snow blower

attachment for their machines.

K. D. Brewer 2008

Page 4-26

Working Capital

If the company launches a new product line,

there is likely to be a new category of inventory

created. Some of this inventory will have been

received before they have to make payment

(accounts payable). It is also likely that some of

the goods that they have sold were sold on

credit and the company has not yet received

payment (accounts receivable). The inventory +

receivables - payables = net working capital.

This commitment of assets is a requirement of

proceeding with the project, so it is a relevant

cash flow. If the project is of a limited duration,

then the net working capital will be freed up as

the project winds down and would become a

positive terminal cash flow.

Net working capital can be negative in the case

of a new inventory management system.

K. D. Brewer 2008

Page 4-27

Financing Costs

How the money to finance the project is raised is

not relevant to the project in terms of cash flows.

Therefore, any interest, principal or dividend

payments that are related to the financing of the

project are not relevant cash flows for capital

budgeting purposes.

The major reason for this is that the cost of

financing the project is already reflected in the

discount rate used in NPV, MIRR, DPB and PI,

and is also the benchmark rate used for IRR. If

we included the cost of financing in the cash

flows as well, we would be counting that cost

twice.

What if the company can get a no interest loan

from the government for the project? In that

case the difference between the amount

received and the amount that would have been

received with alternative financing is a positive

cash flow for the company.

K. D. Brewer 2008

Page 4-28

Inflation

When we were looking at bonds, we noted that

the rate of inflation had an impact on the rate of

return that potential investors demanded before

they would invest in a security. This was called

the Fisher effect.

The discount rate is that we are using is based

upon the rate of return the company has to

promise to convince investors to invest in the

company. Therefore the effect of inflation has

been incorporated the discount rate. As a result,

we should adjust the projected cash flows for the

expected rate of inflation as well. If we don't do

that then we will bias the decision making

process against long term projects.

K. D. Brewer 2008

Page 4-29

Government

Intervention

The various levels of government can have an

impact on the cash flows of a project.

This impact can be quite noticeable and direct in

the case of grants and tax credits. The benefits

associated with subsidized loans and favorable

tax treatment can also be calculated. In the

case of grants, the grant is a positive cash flow.

An investment tax credit is also a positive cash

flow since it negates a negative cash flow,

though it may reduce future tax deductions

which would have to be accounted for as well. A

subsidized loan can also be seen as a cash

inflow, being the difference between how much

we can borrow vs. how much we could borrow

without the subsidy if we made the required

payments.

K. D. Brewer 2008

Page 4-30

well, with specific taxes and regulations that

make a project more expensive.

K. D. Brewer 2008

Page 4-31

One method of evaluating a project is to take the

forecasted revenues and costs and plug those

into projected or pro forma financial statements. If

you are very comfortable with accounting or are

planning to calculate AAR, these pro forma

statements are very useful. From a finance

point of view, I find them of somewhat limited

use. A major reason that I find them of limited

use is that they add accounting items such as

depreciation and then have to back them out to

get the project cash flows. I find it easier to just

calculate the cash flows directly.

With a pro forma statement, you would construct

an income statement using: sales - COGS other costs - depreciation - taxes = net income.

You would also construct a depreciation

schedule for the assets in use. To get the cash

flows you add back depreciation.

K. D. Brewer 2008

Page 4-32

Accounting Difficulties

There are several other problems with using

accounting numbers in capital budgeting, and

many of them revolve around a central concept

of accounting, the matching principal. With the

matching principal, accounting tries to match the

timing of the revenue with the expense, ignoring

the time value of money. A firm selling washing

machines that come with a 7-year warrantee will

declare a warrantee expense in the year of sale

that is an estimate of how much the firm will

spend on covered repairs even though they will

not actually spend all of that money for 7 years.

Accounting numbers are not even that useful for

estimating the taxes payable, the warrantee

expense above is not allowed for tax purposes.

Also depreciation is calculated differently for tax

and financial reporting.

Further the accounting numbers often include

sunk costs and exclude opportunity costs.

K. D. Brewer 2008

Page 4-33

Taxes

One thing that is inevitable when a company is

considering a profitable investment opportunity

is taxes. For this reason the cash flows of the

project must be stated on an after tax basis. To

do this we assume that almost all cash flows are

taxable income if positive and tax deductible if

negative. These cash flows are then reduced by

the amount of tax paid or saved. The method of

doing this is to multiply all cash flows that are

taxable by (1 - t) where t is the firm's marginal

rate of tax. (See chapter 2.4)

Several forms of income are treated differently.

Dividends are not taxable for corporations. Also

capital gains are treated differently. Only one

half of the capital gain has to be included in the

firm's income for tax purposes. Previously the

inclusion rate had been 75% or 2/3 depending

on the year since tax laws change over time.

K. D. Brewer 2008

Page 4-34

Taxable Losses

In some cases a company will report a taxable

capital or operating loss in given year. The tax

laws allow such losses to be carried back up to

3 years and carried forward up to 7 years for an

operating loss and indefinitely for a capital loss.

Capital losses can only be applied against

capital gains.

The carry back provision allows a company to

offset previous taxable gains and recover some

of the taxes that were paid on those gains. If

there are not enough previous earnings in the

carry back period, the firm does not have to pay

taxes on future gains until those profits have

exceeded the losses reported, or until those

losses expire.

If two firms merge, the new firm can use taxable

losses from either firm.

K. D. Brewer 2008

Page 4-35

Capital Assets

The main cash flow that is treated differently for

tax purposes is the initial investment. In most

cases the initial investment must be capitalized.

This means that although the cost is incurred up

front the investment is deducted over the life of

the project instead of when it is incurred. The

main reason for this is that the investment has

resulted in the acquisition of a fixed asset that

still has most of its value. As such it is seen as

an investment rather than an expense.

This investment however declines in value as it

generates income. For this reason the value of

the investment is expensed over time. Financial

reporting depreciation is quite influenced by

managerial decisions and is not allowed for tax

reporting in Canada or the USA. For tax

purposes the Capital Cost Allowance or CCA is

the only allowable method of depreciation in

Canada. (See chapter 2.5)

K. D. Brewer 2008

Page 4-36

CCA

Instead of allowing each firm's management to

decide what depreciation policy to use, the

government specifies that policy. Each asset is

assigned to an asset class based on the tax

code. When an asset is acquired, the value of

the asset is added to the value of that asset

class on the firm's books. In effect, all assets of

a single class are pooled and treated as one

asset for depreciation purposes.

Each year the firm is allowed to deduct from

taxable income a percentage of the value of

each as class specified in the tax code. The

amount that is deducted as an expense is also

subtracted from the balance of the asset class.

For example if the firm has $100,000 in asset

class 9 (electrical equipment), it is allowed to

deduct 25% or $25,000 as an expense. The

pool would also be reduced by this amount

leaving a UCC of $75,000.

K. D. Brewer 2008

Page 4-37

Half-Year Rule

If the value of the pool increases over the year,

only half of the net increase is usable in the

calculation of the allowable CCA expense.

If the firm in the previous example added a new

asset to the pool with a cost of $25,000, the

undepreciated capital cost of the pool (UCC)

would be $100,000 but only half of that increase

can be used in the first year. Therefore the firm

can only claim a maximum deduction of 25% of

$87,500 or $21,875. This would leave a UCC of

$78,125.

Year

Starting UCC

100,000

25,000

75,000

100,000*

21,875

78,125

78,125

19,531

58,594

58,594

14,648

43,945

43,945

10,986

32,959

K. D. Brewer 2008

Page 4-38

Asset Sales

If the firm disposes of an asset, the net proceeds

from disposition (the selling price less any costs)

is deducted from the UCC of the asset class, up

to a maximum of the original cost. Anything

above that is treated as a capital gain.

If the sale of an asset leaves the pool with a

negative balance, the entire amount is added to

the firm's taxable income that year. This is

called recaptured depreciation. In effect the tax

people realize that they have allowed the firm to

deduct too much depreciation and they want it

back.

If the sale leaves no assets in the pool, but a

positive UCC, the firm has a terminal loss and

can deduct the entire UCC that year. If a single

asset remains in the class and the UCC is 100

times the cost of that asset, there is no terminal

loss.

K. D. Brewer 2008

Page 4-39

Complications

The above description of CCA applies to most

assets. Some assets are treated differently.

1. Land is not depreciable under CCA.

2. Certain assets are not pooled. Each asset of

that class is treated as a separate class.

3. Leasehold improvements are depreciated on

a straight-line basis over the life of the lease.

4. Intangible assets with a limited life (patents,

licenses, etc.) are depreciated on a straightline basis over the life of the asset.

5. Timber and mining rights are depreciated in

a different manner.

I don't expect students to be tax accountants, if

something is treated differently, I'll specify that in

any questions asked.

K. D. Brewer 2008

Page 4-40

How much tax does a company save due to

CCA? Assume a company with a marginal tax

rate of 35%, and a cost of capital of 15%. What

would the tax savings be over 5 years, on a

class 8 asset (manufacturing machinery, 20%)

that cost $100,000? What is the present value

of those tax savings?

Year

1

2

3

4

5

UCC, start

CCA

100,000 10,000*

90,000 18,000

72,000 14,400

57,600

11,520

46,080

9,216

36,864

Tax Benefit

3,500

6,300

5,040

4,032

3,226

PV

3,043

4,764

3,314

2,305

1,604

15,030

machine for $50,000 at that point?

1. In most cases there will be no immediate tax

effect, the UCC is reduced by $50,000.

2. If it was the only asset in the class and not

replaced, $13,136 would be recaptured.

K. D. Brewer 2008

Page 4-41

PV of Tax Shield

If an asset is added to the pool and never

removed from the pool, the tax savings will

continue forever.

Each year the amount of the tax savings will

decrease by the CCA rate.

This is a declining perpetuity.

This can be considered the same as a

growing perpetuity with a negative growth

rate.

We already have a formula for a growing

perpetuity under equity, the Gordon Growth

Model.

If we replace D1 with the tax savings in the

first year (ignoring the half-year rule) we get:

PVtax shield

CdTc

rd

K. D. Brewer 2008

Where:

C = the initial cost of the asset

d = the CCA depreciation rate

Tc = the marginal tax rate

r = the cost of capital

Page 4-42

The existence of Revenue Canada's half-year

rule complicates things. The easiest approach

to adjusting for that rule is to split the initial

investment into two pieces, the first of which is

depreciated as above, the second is calculated

the same way, but since it doesn't start until next

year we discount that for one period.

PVtax shield

1 CdTc 1 CdTc

1

2

2

rd

rd

1 r

1 CdTc

1

2

1

rd

1 r

r

CdTc 1 2

r d 1 r

switching from r to k for the discount rate when

the discount rate is the cost of capital. This is

common in financial literature.

K. D. Brewer 2008

Page 4-43

Salvage Value

In most cases, the firm will not keep an asset

forever. What happens when the firm disposes

of the asset?

1. If the net salvage value is zero or lower and

there are other assets in the class, there is

no effect on the present value. The portion

of the pool that the asset represented

continues to depreciate forever.

2. If the net salvage value is positive, less than

the UCC and the original cost, and the pool

is not left empty or with a negative UCC, the

net salvage value is deducted from the UCC

and the firm loses the tax shield on the net

salvage value.

PVlost tax shield

SdTc

1

r d 1 r t

can ignore them during capital budgeting.

K. D. Brewer 2008

Page 4-44

An Example

DCF Inc. is considering a capital budgeting

proposal to replace an obsolete machine. The

old machine was purchased 2 years ago for

$200,000. It had an expected life of 7 years with

a salvage value of $22,500. The machine is

being depreciated on a straight-line basis for

financial reporting purposes and is in asset class

8 (20%) for CCA. The old machine would only

net $30,000 for parts if sold today. The new

machine is also asset class 8, costs $25,000 it

has an expected life of 5 years with no salvage

value. The asset class will not be left empty at

that time. The new machine produces less

waste for an after-tax cost saving of $2,000 in

the first year, increasing at the rate of inflation

forecast at 3% annually. It would also reduce

inventory by $200 and A/P by $100.

What are the relevant cash flows and is this

project acceptable if DCF's cost of capital is 17%

and its marginal tax rate it 38%?

K. D. Brewer 2008

Page 4-45

Cash Flows

1. The original purchase price and depreciation

can be ignored.

2. The $30,000 for parts is netted against the

investment of $25,000.

Net investment

would be -$5,000, a cash inflow.

3. The UCC for class 8 would decrease by

$5,000. The PV of that loss of tax shield

would be -$1,027 (no half-year rule).

4. The reduction of working capital of $100 is

also a relevant cash inflow at time zero.

5. Cost savings of 2000, 2060, 2122, 2185,

2251 would be relevant over the five years.

6. In Year 5 there is a negative cash flow of

$22,500. If the machine is not replaced they

can sell it for $22,500 in 5 years. Of course

this is reduced by the tax shield lost.

7. The working capital change is likely to be

permanent.

K. D. Brewer 2008

Page 4-46

Decision

Net cash flows for the project are:

DCF Inc.

Purchase

Sale of asset

CCA on net investment

Inventory

Accounts payable

Cost savings Year 1

Cost savings Year 2

Cost savings Year 3

Cost savings Year 4

Cost savings Year 5

Forgone Salvage Year 5

CCA on lost salvage

Payback = 0

Cash Flow

-25,000.00

30,000.00

-1,027.03

200.00

PV @ 17.0%

-25,000.00

30,000.00

-1,027.03

200.00

-100.00

-100.00

2,000.00

2,060.00

2,121.80

2,185.45

2,251.02

-22,500.00

4,621.62

NPV =

IRR =

PI =

1,709.40

1,504.86

1,324.79

1,166.27

1,026.71

-10,262.50

1,873.75

2,416.26

5.52%

-0.5167

which recommends the project. The IRR is less

than the cost of capital and the PI is negative.

These actually recommend the project since the

decision criteria reverse if the initial investment

is negative.

K. D. Brewer 2008

Page 4-47

Project

Interdependence

Sometimes when one or more projects are

under consideration, the decision regarding one

of the projects can have an impact on the cash

flows of another project under consideration.

Complementary

Positive interdependence

Independent

Negative interdependence

Mutually exclusive

K. D. Brewer 2008

Page 4-48

Interdependence II

With complementary projects, project B can only

be undertaken if project A is accepted. When

analyzing the projects, consider A alone and

A+B as a single project. Whichever of those has

the best NPV is what the firm should do.

Interdependent projects have an overlap, either

positive or negative on the cash flows of the

other projects. In that case find the NPV of all of

the project combinations that are possible. The

combination that has the highest NPV

(assuming that it is positive) is the option that

should be undertaken.

If projects are independent then accepting one

has no bearing on the others. Accept a project if

it has a positive NPV.

Only one of the mutually exclusive projects can

be accepted. Choose the one with the highest

net present value (if positive).

K. D. Brewer 2008

Page 4-49

Interdependence III

ADC Limited is considering two proposals for

developments on a remote site. Both projects

can be accommodated on the site. Project A

has a net present value of $5,000 and an initial

cost of $500,000. Project B has an initial cost of

$250,000 and a NPV of -$10,000. Both projects

include a cost of $100,000 to extend power lines

to the site. This cost only needs to be paid by

one of the projects. What should ADC decide?

Project A: NPV = $5.000

Project B: NPV = -$10.000

Project A + B: NPV = $95,000

In general if the sum of the NPVs is not the

same as the NPV of the combined project then

the projects are interdependent.

K. D. Brewer 2008

Page 4-50

Unequal Lives

With mutually exclusive projects, a difference in

the length of the project can alter which decision

is correct if the projects are repeatable.

MFM Inc. is considering 2 proposals to replace a

piece of production machinery. Proposal A has

a NPV of $200,000 over its 3-year life. Proposal

B would have a life of 6 years and a NPV of

$300,000. Both proposals can be repeated.

Which proposal should MFM accept if they have

a cost of capital of 15%?

Using the normal NPV rule, MFM would accept

Proposal B. However, if they accept Proposal A,

they can do that project twice in the time that

Proposal B takes. MFM can do a $200,000 NPV

project starting at time 0, and again at time 3.

The second time has an NPV of $131,503

($200,000 3 years from now) for a total of

$331,503 for doing proposal A twice.

K. D. Brewer 2008

Page 4-51

EAA

The tactic of finding the NPV of a series of

projects that set the two projects to equal lives is

termed a project chain. If one project is half the

life of the other project, this approach is quite

simple. If you have 2 projects with lives of 7

years and 9 years, you would have to do the first

project 9 times and the second project 7 times.

This is quite clumsy.

A different approach would be to find out how

much NPV is added for each year of the project.

To find the EAA, or Effective Annual Annuity, we

divide the NPV of each project by the PVIFA at

the cost of capital with a number of payments

equal to the life of the project. The firm should

be indifferent to gaining an annuity with those

payments or proceeding with the project.

K. D. Brewer 2008

Page 4-52

EAA Example

How much would MFM have to receive each

year to yield the same NPV as the two projects?

$200,000 = EAAA x PVIFA(15%, 3)

EAAA = $87,595

$300,000 = EAAB x PVIFA(15%, 6)

EAAB = $79,721

Using the EAA we see that Proposal A actually

has a higher net present value added per year

than Proposal B.

If the projects cannot be repeated, the straight

NPV is the appropriate decision criterion.

The text calls this EAC or effective annual cost.

They only apply EAC to required expenses.

EAA is useful when considering any mutually

exclusive projects that can be repeated.

K. D. Brewer 2008

Page 4-53

Forecasting Risk

If we have a forecast of project cash flows of

$5,000 per year for 5 years, do we actually

expect to have exactly $5,000 in cash flows in

each of the next 5 years?

It is not likely. The project's cash flows are

based on estimates of sales and costs. We do

not know for certain the level of sales in the

future, and even if we did (long term contract)

the level of costs could easily change.

If we take a weighted average of the possible

outcomes, the cash flows should be $5,000. For

example; a 10% chance of $7,500, 20% chance

of $6,000, 50% chance of $5,000 and a 20%

chance that the cash flow would be $2,750

would give the project an expected cash flow of

$5,000.

The chance that our estimated cash flows are

wrong is called forecasting risk.

K. D. Brewer 2008

Page 4-54

Dealing with

Forecasting Risk

How would we control for forecasting risk?

There are several options to deal with this risk.

We can construct multiple models of cash flows

and see how much of an impact the various

assumptions that we have made have on the

project's cash flows. Depending on the method

used this type of analysis can be called;

scenario, what-if, sensitivity, simulation, or breakeven analysis.

All of these do similar things. The basic idea is

to find out how much our cash flow projections

can be off and still recommend the project. If a

minor difference in an assumption can make the

project unattractive, we should examine the

project more carefully. This form of analysis is

simple with a well-constructed spreadsheet.

K. D. Brewer 2008

Page 4-55

Managerial Options

One implicit assumption that we have made in

our earlier cash flow models is that once the

project has been launched, it will continue to

operate at a certain level throughout it's life.

How would this change if management has

the ability to alter the operations of the firm

when they get more information about the

actual results of the project?

What sort of decisions can management

make during the life of the project?

Can we enhance the value of a project by

considering these managerial options?

Would it be worthwhile to spend more initially

if we increase the flexibility of operations?

K. D. Brewer 2008

Page 4-56

Types of Options

Expansion options: if sales and/or profits are

better than forecast, is the project able to be

expanded to take advantage of this opportunity?

If the project can be expanded, how much is that

going to cost? Is there anything we can do at

the start to enhance this opportunity? Can a

minor increase in startup costs significantly

reduce the cost of expansion?

Contraction options: if sales fall short of our

projections, can we scale back production to

significantly reduce costs? A project that has

low fixed costs and high variable costs (low

operating leverage) will be able to realize more

savings from contraction than a project with high

fixed costs and low variable costs will have less

opportunity to cut costs, but may be better able

to expand production.

K. D. Brewer 2008

Page 4-57

More Options

Abandonment options: if things go wrong in a

big way, can the firm get out of this project and

recover much of their investment? Alternatively

can we use the investment that was made for

this project for some other project? The option

to abandon the project if things do not work out

right can be a valuable option.

The option to wait: sometimes, it might be in the

best interests of the firm to wait for more

information before making a decision on an

investment. For example, the firm is considering

an expansion of existing capacity. The firm has

submitted a bid for a major contract. If they are

awarded that contract they will need a major

expansion of capacity, if not, then a minor

increase in capacity is more appropriate. In that

case, it may be in the firm's best interest to wait

for that decision before committing to either

project.

K. D. Brewer 2008

Page 4-58

Other Options

Tax options: some flexibility in operations can

have a large impact on the taxes paid by a firm.

For example if there are few assets left in an

asset class and a large UCC, disposing of those

assets could trigger a large terminal loss, saving

the company a significant amount of current

taxes payable.

Strategic options: sometimes a company will

accept a project with a negative NPV in order to

explore possible opportunities (McDonald's in

Moscow) or because they expect some of the

expenses to reduce the cost of other projects.

In the positive interdependence example, if only

project B was being considered, its -$10,000

NPV would normally be enough to reject the

project, but accepting the project opens up the

site for other proposals, so it might be accepted

when the strategic options are considered.

K. D. Brewer 2008

Page 4-59

Managerial Options

Example

Crispy Corp. has a cost of capital of 12%.

Management is considering a capital budgeting

proposal that would require an initial investment

of $2 million. Annual cash flows are forecast at

$300,000 per year for 10 years with no salvage

value.

The $300,000 annual cash flow is

actually a weighted average of $400,000 and

200,000 (based on market reaction) and the

cash flow for the life of the project will be known

after one year of operation.

What is the net present value of the project?

NPV = -$2 m + 300,000xPVIFA(12%, 10)

NPV = -$304,933

Ignoring options the project has a negative NPV

and is not worth considering.

K. D. Brewer 2008

Page 4-60

If the project includes an option to double the

cash flows if market reaction is good ($400,000)

for an additional investment of $1 million at the

end of year 1, find the NPV taking into account

this expansion option.

To find the NPV we split the calculation into two

cases, find the NPV of the two cases and

average them.

Year

0

1

2

3

4

5

6

7

8

9

10

CF

DCF

-2000

-2,000

-600

-536

800

638

800

569

800

508

800

454

800

405

800

362

800

323

800

288

800

258

1,270

NPV with Option =

CF

DCF

-2,000

-2,000

200

179

200

159

200

142

200

127

200

113

200

101

200

90

200

81

200

72

200

64

-870

200.11

K. D. Brewer 2008

Page 4-61

Would an option to shut the project down after

one year for a salvage value of $1 million be

useful to Crispy Corp.?

Crispy Corp. would only consider this option if

the low cash flow scenario were realized. The

way to evaluate this is to see if they would use

this option in this case. The option gives Crispy

Corp. the opportunity to get $1 million in

exchange for the remaining cash flows of

$200,000 per year for 9 years. Those cash

flows have a present value of $1.066 million,

which is more than what would be realized if

they shut down the project. Therefore this

abandonment option would not be valuable to

Crispy Corp. If they option would have yielded

more than $1.066 million, that option would have

had value.

K. D. Brewer 2008

Page 4-62

Capital Rationing

If the firm has a limited amount of money

available for capital spending and has more

positive NPV projects than this, we have a

situation that is called capital rationing.

If the firm has only allocated a limited amount of

money, but can raise more if necessary this is

called soft rationing. Under soft rationing, if the

available positive NPV projects require more

funds than are allocated, the rational course of

action is to attempt to get more funds. Failing

that we should try to get the maximum NPV by

choosing the projects with the highest PI first.

This can be complicated if the soft rationing is a

one-time event and some of the projects can be

delayed at no reduction in cash flows.

Under hard rationing the firm cannot raise any

more money for capital spending under any

circumstances.

K. D. Brewer 2008

Page 4-63

Capital Rationing II

The text argues that capital rationing is not

consistent with the goal of maximizing the value

of the firm and spends very little space on this

issue. There are multiple possible reasons that

capital rationing can occur in real life.

A firm with a market capitalization of $10 million

is not likely to be able to raise $1 billion for a

capital investment project. That $10 million firm

is likely to find that there is a level of capital

spending, above which the cost of raising new

capital starts to increase. In other words, a firm

can only raise a limited amount of funds at their

current cost of capital. If they want to invest

more than that amount, they have to take into

account the increased cost of funds and how

this would affect the value of the company.

Protective covenants in a previous bond issue

may also prevent the company from pursuing all

positive NPV projects.

K. D. Brewer 2008

Page 4-64

Capital Rationing

Example

HCR Limited has a cap on capital spending of

$5 million due to a bond covenant. Currently

HCR had six positive NPV projects that it would

like to undertake. They are (in $thousands)

Project

A

B

C

D

E

F

Total

Cost

1,300

1,700

3,000

500

2,200

1,900

10,600

PI

1.10

1.07

1.06

1.20

1.05

1.18

NPV

?

?

?

?

?

?

should HCR Limited allocate their spending

assuming that all of the projects can be delayed

with no adverse effects?

K. D. Brewer 2008

Page 4-65

Rationing Solution

To find the NPV of each project, simply multiply

the cost by (PI-1). The PI is the present value of

the future cash flows divided by the cost, the

NPV is the present value of the future cash flows

minus the cost.

To decide how to allocate funds, rank the

projects according to the PI.

Project

D

F

A

B

C

E

Cost

PI

NPV

Cost

500

1.20

100

500

1,900

1.18

342

2400

1,300

1.10

130

3700

1,700

1.07

119

5400

3,000

1.06

180

8400

2,200

1.05

110 10,600

10,600

HCR could afford to do projects D, F, and A.

This has a NPV of $572. To do Project B would

require $1,700 and they only have $1,300 left.

They can afford B if they skip D, that would

increase the NPV by $19. The ideal choice of

projects is A, B and F.

K. D. Brewer 2008

Page 4-66

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