6 Chapter_7_-_student.pptx

7/27/2019 6 Chapter_7_-_student.pptx

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Chapter 7

Fundamentals of CapitalBudgeting

FIN 2200 Corporate Finance

Dennis Ngstudent Version


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Outline1. Relevant Cash Flows2. Taxes: more detail3. CCA: a closer look4. DuoCity Taxi example


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The main principles behind which cashflows to include in capital budgetinganalysis are as follows:

1. Only include cash flows that change as aresult of the project being analyzed.Include all cash flows that are impacted bythe project. This is often called anincremental analysis of the free cash flows look at how cash flows change betweennot doing the project vs. doing the project.

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1. Relevant cash flows


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Relevant cash flows

2. Use projections of cash flows, notaccounting income. Accounting income cash. Accounting income

cannot be spent, a firm can be losing cash buthave positive accounting income, so accounting

income is not necessarily representative of cash.Cash is what really generates value; cash can bespent!

Accounting income may depend on somewhatarbitrary accounting policies, income can easilybe manipulated, so, by itself, it is not a reliableinput for capital budgeting analysis.

We need to convert accounting numbers intoFree Cash Flows


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Which cash flows are relevant tothe project analysis, which are not?

Sunk Costs: A cost that occurred in the past andcannot be removed.

Example: Healthy Life spent $5 million to test a newdrug. Now it is considering building a new plant toproduce the new drug.

Is the $5 million relevant to the analysis of the newplant project?

Opportunity costs: The return (or cash flows) thatcould have been earned if a project is not taken.

Example: The new plant will use some land owned byHealthy Life. If Healthy Life does not take the new plantproject, the land can be sold for $7 million.



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Side effects: Effects of a proposed project on otherparts of the firm.

Example: If Healthy Life begins to sell the newdrug, some customers will stop buying one of the

existing drugs made by Healthy Life. The resulting cashflow loss will be $1 million per year.


Interest Expense: Many projects are partially financed

with debt. However, we do not consider interestexpense in our cash flow analysis. Instead, it will beconsidered later in estimation of discount rate (cost ofcapital). This is the only exception to the relevant cashflow principle.

Which cash flows are relevant tothe project analysis, which are not?


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A start to finding free cash flow

As a starting point, we can begin withincremental accounting figures:

EBIT (1-Tc)

Remember, this excludes the effect ofinterest.

Also, we must manually exclude sunkcosts and include opportunity costs andside effects


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A start to finding free cash flow

Recall that asset purchases or salesare often not reflected in accountingincome. Therefore we should subtractthe cash used for purchases and addthe cash received for asset sales

EBIT (1-Tc) asset purchases + asset sales

Still more is needed though!


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Net Working Capital Changes Requiredby the Project the cash flow effects

Net Working capital (NWC) items do not show up ascosts or revenues, however changes to the NWCitems either require or free-up cash.

Increases in current assets required for the projectimply that cash is used a cash outflow occurs.

To increase inventories requires cash. To increase the cash-register float also requires cash.

An increase in accounts receivable (AR) means thatthe cash you may have recognized, through revenue,hasnt been received yet. In effect, if your project

requires you to increase credit for your customers(an AR increase), then this uses up cash that youwould otherwise have.


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More on Net Working Capitalchanges

Increases in current liabilities, on the other hand,free-up cash a cash inflow occurs. Increasing accounts payable (AP) means that a cost

cash flow you may have recognized elsewhere (as anoutflow) has not yet been paid, therefore theincrease in AP is a cash saving or inflow.

For other payables, the analysis is the same. Salaries payable, utilities payable, etc.

Overall, changes in net working capital (NWC)represent cash flows. If NWC increases, the increase is counted as a cash

outflow. If NWC decreases, the decrease is counted as a cash

inflow.


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Net Working Capital: Example

Without the Project With the Project

WCitem

2005 2006 2007 2008

Inven. $10 $11 $12 $13

AR $20 $21 $26 $28

AP $5 $6 $10 $13

NWC

WCitem

2005 2006 2007 2008

Inven. $10 $12 $14 $13

AR $20 $26 $28 $28

AP $5 $8 $13 $13

NWC


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NWC Solution

12Year 2006 2007 2008 2009Withoutthe project NWC $25 $26 $28 $28With theproject

NWC$25 $30 $29 $28

Project incremental NWCIncremental NWC Cash Flows

Note: over the entire life of a project, the incremental NWC cashflows normally sum up to zero. This is because the working capitalamounts should revert to the no project amounts once the projectis totally finished.


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Further toward finding free cashflow

We can continue by adjusting for changes in NetWorking Capital (that either includes or excludes thecash component depending on whether the cash isnecessary for the investment)

EBIT (1-Tc) (asset purchases asset sales) NWC

Also, we should note that CCA (depreciation for taxpurposes) is a non-cash expense (but it does reduce taxes)therefore we include the CCA tax shield but add back the CCA

EBIT (1-Tc) net capital expenditures NWC + CCA

net capital expenditures


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EBIT (1-Tc) net capital expenditures NWC + CCA

Note: EBIT = (Revenues Costs CCA) thus the aboveequation can be rewritten as follows:

(Revs Costs)(1-Tc) net cap expend NWC + CCA Tc

CCA is the depreciation used for tax purposes in Canada.

As long as we have excluded sunk costs and other itemsnot affected by the project and as long as we haveincluded opportunity costs and other side effects causedby the project, the above equation represents the FreeCash Flow of the project that can be used in the NPVanalysis.

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Free cash flow


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2. Taxes: more detail

In most countries both corporationsand individuals must pay tax onincome and profits.

Tax is a cash outflow. So we mustinclude taxes in our capital budgetinganalysis.


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Calculating tax effects from non-financingcomponents of the income statement.

Recall the incomestatement you learnedabout in accounting

Whatever affects theincome statementamounts will also affect

the taxes paid. *Assume depreciation has

been replaced here withCCA, which is recognizedfor tax purposes.

**The interest expense isfinancing related, so

interest and its tax effectshould be removed fromour analysis.

Revenues $1,000

Cost of goods sold $600

Gross Margin $400

Selling, general, and

admin expenses

$125

R&D expense $50

CCA deduction* $100

Interest Expense** $25

Earnings Before Tax $100Tax (at 40%) $40

Earnings after Tax(Net Income)

$60


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Tax consequences and after tax cashflows (assume a tax rate, Tc, of 40%)

Item Before-taxamount

Before-taxcash flow

After-taxcash flow

Revenue Rev

$10

Rev

$10

=Rev(1-Tc)

=$10(1-.4)

=$6

Expense Exp

$10

-Exp

-$10

=-Exp(1-Tc)

=-$10(1-.4)

=-$6CCA CCA

$10

$0 =+CCATc=+$10 0.4

=+$4


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3. CCA: A Closer Look

Capital Cost Allowance (CCA) isdepreciation for the purposes of taxes inCanada.

CCA is used to determine taxable income.

CCA is not the same as depreciation underthe General Accepted AccountingPrincipals (GAAP) (or the new IFRS)

e.g. firms are allowed to use theaccelerated CCA method (decliningbalance) in calculating taxable incomewhile using other methods (e.g. straightline depreciation) for accounting income.


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CCA (contd)

CCA calculations begin by identifying the asset aspart of a pre-defined asset class. Individualassets in each class lose their identity since they

become a part of a pool value. CCA is thencalculated based on the balance of undepreciatedcapital cost (UCC) for each pool.

Special case: the half-year rule

When an asset is first put into an asset pool, only halfof its original cost is allowable in the first year.

The remaining half of the assets cost is added to thepool at the start of the second year.


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CCA Calculations: Example

The cost of a new asset is $1,000. The CCArate is 40%. The corporate tax rate is 20%.

Lets look at the tax shields created by this

asset in separate parts.

Consider the addition of of the asset costinto the asset pool at the start of the first year

only. The following table indicates thecalculations of CCA, UCC, and resulting CCATax Shield (cash inflow) for each year.


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The cost of a new asset is $1,000. The CCA rate is 40%.The corporate tax rate is 20%. Can you calculate the PV ofthe tax shields of the first half of the assets cost if thecost of capital is 10%?


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CCA Calculations: Example (contd)

We can see that the series of cash flowscreated by the CCA deductions (the taxshields) has the following characteristics:

The cash flow stream goes on forever

Each cash flow changes from the previous one

by a constant rate.

In this example, the growth rate is negative, andhappens to be equal to the negative of the CCA rate


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Notation: CCA rate = d; discount rate = k; asset cost =C; Tax rate = Tc

Recall the PV of the growing perpetuity can be solved by

PV0

Cash flow1rg

PV0 .5 C d Tc

(k (d))

PV0 .5 C d Tc

(k d)

80$

40.10.

20.40.500$0

PV


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The second half of the asset is added in at the start of year2. The cash flow stream it creates (tax shields) is identicalto the first half, just beginning one year later. What is thePV of this growing perpetuity?

Year Beg. UCC CCA End. UCC

CCA Tax

Shield

1

2 500.00$ 200.00$ 300.00$ 40.00$

3 300.00$ 120.00$ 180.00$ 24.00$

4 180.00$ 72.00$ 108.00$ 14.40$

: : : : :


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We have a growing perpetuity with:

The first cash flow at time 2

A negative growth rate

PV0 .5 C d Tc

(k d) 1

1 k

PV0

$500 .40 .20 .10 .40

1

1.10 $72.73


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Combining the two PVs we get:

$80 + $72.73 = $152.73

Now, how would the CCA calculationslook if we combined everything into one

table?


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The total effects of the $1000 asset can be seen below.Remember, $500 of the asset is added to the pool now;$500 is added one year from now.

Year Beg. UCC CCA End. UCC

CCA Tax

Shield

1 500.00$ 200.00$ 300.00$ 40.00$

2 800.00$ 320.00$ 480.00$ 64.00$

3 480.00$ 192.00$ 288.00$ 38.40$

4 288.00$ 115.20$ 172.80$ 23.04$

: : : : :


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Combining the two PV formulas we get:

PV0 .5 C d Tc

(k d)

.5 C d Tc(k d)

1

1 k

PV0 C d Tc(k d)

1

k

2

1 k

PV0 $1000 .40 .20

.10 .40

1 .05 1.10

$152.73


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PV CCA Tax Shields with the Half-Year Rule

C = Cost of asset

d = CCA rate

Tc = Corporate tax rate

k = Discount rate for CCA tax shields S = Salvage value of asset

n = Asset life in years

Note: In this course, assume no capital gains on disposal of theasset. Also, assume asset pool is not terminated upon disposal ofthe projects asset.

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ShieldsTaxCCA

k

k

dk

TdCPV

c

nc

kdk

TdS

1

1

PV growingperpetuity, all tax

shields

Adj. for year rule

PVngrowing

perpetuity,of lost tax

sheilds

Bringingthe singlesum backto time 0


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Summary of Capital BudgetingItems and Tax Effects

NPV = + PVincremental revenues-expenses after taxes1

PVnet capital expenditures2

PVchanges in net working capital2

+ PVCCA tax shields

Footnotes:1. These items usually have the after-tax cash flow equal to the before tax

cash flow multiplied by (1-Tc). Dont forget about opportunity costs andside effects.2. Asset purchase/sales have the same before-tax and after-tax amounts.

I.e., except for capital gains, there is no tax effect the tax effect isthrough the CCA. Similarly, there is no tax effect caused by a change innet working capital.


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DuoCity Taxi is considering expanding its fleet.Present an NPV analysis for the project.

The cost of the new taxis is $1,000,000 now. Taxis fall under CCA Class 16 and are allowed a

CCA rate of 40%. DuoCitys tax rate is 45% and the relevant

opportunity cost of capital is 15%. The project will generate revenues in excess of

expenditures of $450,000 per year for 5 years.

The project will also require an immediate workingcapital increase of $50,000, no intermediatechanges, and a reversion to normal working capitalrequirements at the end of 5 years.

Assume the taxis relevant to this project will besold at the beginning of the 6th year for $100,000.

4. DuoCity Taxi Example

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6 Chapter_7_-_student.pptx