class eight, july 21st, capital budgeting problems an introduction

8/6/2019 Class Eight, July 21st, Capital Budgeting Problems an Introduction

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Capital Budgeting


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Capital Budgeting

Process: Generate project ideas for long-term investments

Estimate the cash flow from assets for the project for

each year of the project

Calculate an appropriate discount rate based on the risk

of the projects future cash flows

Calculate the NPV of the project

Perform sensitivity analysis, scenario analysis etc.

Implement investment decision and monitor results /

progress of project.


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Introduction

The Basic Principles

CCA vs Depreciation

Capital Budgeting Problems Purchase decision

EAC

Cost cutting decisions Replacement decisions

Bid Problems


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The Principles

Stand-alone Principle

Every project is its own firm

T

herefore we are concerned with the projectscash flow from assets


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The Principles

Incremental Cash Flow not Total Cash Flow

It is the extra cash flow that matters


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The Principles

Ignore Financing Costs

Since we are concerned with CFA, interestcosts do not matter here


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Cash Flow from the Assets

CFA = OCF adds to Op NWC capital

spending


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Three Methods

Formula Approach

List Approach

Table (Brute Force) Approach


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Example

Buy a new piece of equipment for $1,000,000.

Will sell in 3 years for its salvage value

$576,000

Will generate sales of 100,000 units per year

Price/unit = $10, VC/unit = 4, fixed costs are

$50,000 per year

Initial Operating Net Working Capital Required

$100,000


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Example continued

Thereafter Op NWC will be 10% of sales

CCA rate is 20%, tax rate is 40% and required

rate of return is 10%

What is the NPV? Should the firm buy the

equipment?


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Table Approach

Step One: CCA Schedule

Step Two: Pro-forma I/S and OCF

Step Three: Pro-forma Op NWC and CFA


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CCA

Government system of depreciation

Uses classes of assets not individual assets

Uses a declining balance approach

Since CCA involves a declining balance

approach the asset will be depreciated forever

Uses the half year rule.


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Example CCA Schedule

Year Beginning

Undepreciated

Capital Cost (UCC)

Capital Cost

Allowance

Ending UCC

1 500,000 100,000 400,000

2 900,000 180,000 720,000

3 720,000 144,000 576,000


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CCA notes

In the first year, company is able to claim only

of the expected CCA expense

This is due to the year rule


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Example I/S and OCF

Year 0 Year 1 Year 2 Year 3

Revenues 1,000,000 1,000,000 1,000,000

Variable Costs 400,000 400,000 400,000

Fixed Costs 50,000 50,000 50,000

EBITDA 550,000 550,000 550,000

CCA 100,000 180,000 144,000

EBIT 450,000 370,000 406,000

Taxes 180,000 148,000 162,400

OCF 370,000 402,000 387,600


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Pro-forma I/S Calculations

Revenues = units * price/unit

Variable Costs = units * VC/unit

Note the schedule does not include Net

Income


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Example Op NWC and CFA

Year 0 Year 1 Year 2 Year 3

OCF 370,000 402,000 387,600

Op NWC 100,000 100,000 100,000 100,000

Adds to Op

NWC

100,000 0 0 -100,000

Capital

Spending

1,000,000 -576,000

CFA -1,100,000 370,000 402,000 1,063,600


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NPV

NPV = -cost + PV of CFs

NPV = -1,100,000 + 370,000/(1.1)^1 +

402,000/(1.1)^2 + 1,063,600/(1.1)^3

NPV = - 1,100,000 + 1,467,693

NPV = 367,693


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The Formula Approach

Two Important Differences

Instead of OCF we now use OCF*

And

Use the CCA Tax Shield Formula to calculate

benefit of CCA


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OCF*

OCF* = (revs costs) * (1 Tc)

OCF* = (1,000,000 400,000 -50,000)*(1-.4)

OCF* = (550,000) * .6

OCF* = 330,000


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CCA Tax Shield Formula

Note: this formula is only valid if depreciation is calculated on

a declining balance basis.

!

nrdr

SdTr

r

drCdTshieldtaxPV

)1(1

12

11

)(


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Requirements to Use the CCA Tax

Shield

Assume that the asset class always remains open(i.e. there is always a positive UCC balance in theclass and that there are always assets in the class).

If the UCC balance becomes negative (as a result ofselling an asset) or we sell the last remaining asset inthe class then we will trigger either CCA recapture ora terminal loss.

We will not consider either CCA recapture orterminal losses in this course.


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NPV

NPV = 367,693


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The List Approach

Start every Capital Budgeting Problem by

looking for seven items on the list


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Item One

Capital Cost


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Item Two

PV of Salvage Value


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Item Three

Initial Investment in Op NWC


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Item Four

4a PV of Changes in year to year Changes in

Op NWC

4b PV of Op NWC recovered in final year of

project


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Item Five

PV of OCF*


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Item Six

PV of CCA Tax Shield assuming that the SV = 0


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Item Seven

PV of loss CCA Tax Shield, due to selling the

equipment in the future for its Salvage Value


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Example

Item

1 Capital cost -1,000,000

2 PV of SV +432,757.33

3 Initial NWC -100,000

4a Yr to yr changes in NWC 0

4b NWC recovered +75,131.48

5 PV of OCF* +820,661.16

6 PV of CCA TS if SV = 0 +254,545.45

7 PV of loss CCAT

S due to SV -115,401.95NPV 367,693.47


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List Approach NPV

To calculate up the NPV you add up the values

from your list

NOTE: When people speak of the PV of the

CCA Tax Shield they are speaking of items 6

and 7 combined


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Textbook Defn: PV of CCA Tax Shield

PV of CCA TS = 254,545.45 115,401.95

PV of CCA TS = 139,143.50

class eight, july 21st, capital budgeting problems an introduction

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