Learning Objectives

1
Learning Objectives

• Appraise the use of the cost of capital as the
  discount rate in capital budgeting analysis.
  (LO4)
• Integrate the cash flows that result from an
  investment decision, including the after tax
  operating benefits and the tax shield benefits of
  capital cost allowance (amortization). (LO5)
• Perform NPV analysis to assist in the
  decision-making process concerning long-run
  investments. (LO6)

2
Making Investment Decisions
LO6

• When estimating cash flows for an investment
  proposal, remember that only those cash flows
  resulting from the potential acceptance decision
  are relevant and should be included in your
  estimation.
• For example, a proposal of purchasing a new van
  to replace an old van should only include the net
  cost of the new van, that is, the difference
  between the cost of the new van and the sale
  price of the old van.
• The present value of CCA tax shield

3
Table 12-13Net present value of resultant cash
flows at 12
LO6
Investment in Vans Investment in Vans Investment in Vans Investment in Vans Investment in Vans Investment in Vans
Year Cash Flow Amount (1 t) Aftertax Cash Flow Present Value
0 Purchase vans -30,000 --- -30,000
0 Sell old van 500 --- 500
1-4 Operating 17,000 0.61 10,370 31,497
4 Salvage 4,000 --- 2,542
Present value of CCA tax shields (30,000 - 500 - 2,542) (0.263647) Present value of CCA tax shields (30,000 - 500 - 2,542) (0.263647) Present value of CCA tax shields (30,000 - 500 - 2,542) (0.263647) Present value of CCA tax shields (30,000 - 500 - 2,542) (0.263647) Present value of CCA tax shields (30,000 - 500 - 2,542) (0.263647) 7,107
Net present value of resultant cash flows and initial investment Net present value of resultant cash flows and initial investment Net present value of resultant cash flows and initial investment Net present value of resultant cash flows and initial investment Net present value of resultant cash flows and initial investment 11,646
This number is from our calculation using
formula 12-1
4
Table 12-14IRR solution framework using 25
LO6
Investment in Vans Investment in Vans Investment in Vans Investment in Vans Investment in Vans Investment in Vans
Year Cash Flow Amount (1 t) Aftertax Cash Flow Present Value
0 Purchase vans -30,000 --- -30,000
0 Sell old van 500 --- 500
1-4 Operating 17,000 0.61 10,370 24,490
4 Salvage 4,000 --- 1,638
Present value of CCA tax shields Present value of CCA tax shields Present value of CCA tax shields Present value of CCA tax shields Present value of CCA tax shields
(30,000 - 500 - 1,638) (0.30) (0.39) (1 0.5(0.25) 0.25 0.30 1 0.25 (30,000 - 500 - 1,638) (0.30) (0.39) (1 0.5(0.25) 0.25 0.30 1 0.25 (30,000 - 500 - 1,638) (0.30) (0.39) (1 0.5(0.25) 0.25 0.30 1 0.25 (30,000 - 500 - 1,638) (0.30) (0.39) (1 0.5(0.25) 0.25 0.30 1 0.25 (30,000 - 500 - 1,638) (0.30) (0.39) (1 0.5(0.25) 0.25 0.30 1 0.25 5,334
27,862 (0.212727) (0.90) 27,862 (0.212727) (0.90) 27,862 (0.212727) (0.90) 27,862 (0.212727) (0.90) 27,862 (0.212727) (0.90)
Net present value of resultant cash flows and initial investment Net present value of resultant cash flows and initial investment Net present value of resultant cash flows and initial investment Net present value of resultant cash flows and initial investment Net present value of resultant cash flows and initial investment 1,962
5
Making Investment Decisions
LO6

• To make the actual investment decision
• determine the net cash outflow arising from the
  initial investment
• estimate the amounts and timing of net future
  cash inflows (aftertax)
• discount the future cash flows back to the
  present
• add the present value of the Capital Cost
  Allowance shield, using the formula and
  appropriate CCA rate
• determine whether the machine should be purchased
  (if NPV gt 0)

6
Table 12-15Net price of the new computer
LO6

• Price of the new computer . . . . . . . . . . . .
  . . . . . . . . . . . . 150,000
• - Investment tax credit (15) or 22,500 . . . .
  . . . . . . . . . 19,737
• Net price of new computer . . . . . . . . . . . .
  . . . . . . . . . . . . 130,263
• - Cash inflow from sale of old computer . . . . .
  . . . . . . . . 40,000
• Net cost of new computer . . . . . . . . . . . .
  . . . . . . . . . . . . . 90,263
• Our assumption about cash flows (revenues,
  expenses) and tax-initiated cash flows is that
  they occur at the end of the year. Therefore, the
  tax credit of 22,500 is discounted one year. The
  CCA pool is affected in the year after
  acquisition. The CCA tax shield formula is
  constructed assuming tax savings effects occur at
  the end of the year.

7
Table 12-16Differential analysis of new computer
LO6
Year Cash Flow Amount (1 Tax rate) Aftertax Cash Flow Present Value (_at_ 14)
0 New computer -90,263 --- --- -90,263
0 Working capital investment -5,000 --- --- -5,000
1 Cost savings 20,000 0.61 12,200 10,702
2 Cost savings 38,000 0.61 23,180 17,836
3 Cost savings 40,000 0.61 24,400 16,469
4 Cost savings 45,000 0.61 27,450 16,253
5 Cost savings 45,000 0.61 27,450 14,257
5 Salvage 30,000 --- --- 15,581
0 Working capital recovery 5,000 --- --- 2,597
Present value of CCA tax shield benefits (from calculation) Present value of CCA tax shield benefits (from calculation) Present value of CCA tax shield benefits (from calculation) Present value of CCA tax shield benefits (from calculation) 20,490
Net present value Net present value Net present value Net present value 18,922
The present value of all the cost savings may be
handled in one output from the calculator,
particularly if it is an annuity.
8
Discounted Cash Flows Models The Difficulties
LO6

• Both NPV and IRR models require the estimation of
  future expected cash flows and the selection of
  an appropriate opportunity cost of capital.
• There can be difficulties and mistakes estimating
  future cash flows.
• Also bias in estimates based by managers who wish
  to see their project accepted.
• Despite the use of models to determine the
  discount rate, its determination is a judgement
  call.