CHAPTER TEN

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• CHAPTER TEN
• Capital Budgeting
• Basic Framework
• J.D. Han

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Learning Objectives

• 1. Explain net present value (NPV), how it is
  calculated, and why.
• 2. Discuss why generating project ideas and
  estimating cash flows are important.
• 3. Discuss the difference between operating
  profit, net profit, and cash flows in evaluating
  new investments.
• 4. Discuss the internal rate of return (IRR), how
  it is calculated, and why and how it differs from
  net present value.
• 5. Discuss some of the limitations of discounting
  cash flow criteria.

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10.1 Introduction

• There are numerous complexities that need to be
  understood when examining a firms capital
  expenditure decisions such as
• - Generating project ideas
• - Estimating cash flows
• - Evaluating and selecting projects
• - Implementing and abandoning projects

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10.2 Generating Project Ideas

• Generating good project ideas is critical for
  success in capital budgeting
• A firm should pursue only projects in which it
  can create sustainable advantages
• Two ways a company can build competitive
  advantage are
• Differentiation
• Operating more efficiently (low cost producer)

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10.3 Estimating Cash Flows

• Most critical prerequisite for successful capital
  budgeting
• Variable forecasts must be made several years
  into the future for new products or services such
  as
• - Facility expenditures or Initial Investment
• - Sales and product prices or Sales Revenue
• - Operating expenditures
• - Tax and Tax Credit/Shields

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Estimating Cash Flows

• General issues that arise in deriving cash flows
  include
• Relevance of marginal or incremental cash flow
• Time Horizon
• Intangibles
• External Effects
• Effects of price-level changes Inflation
• Financial charges and taxes
• Assumptions

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A Concrete Example of Cash Flows

• When you make an investment on a project
  involving a new machine, there will some cash
  flows
• Gross Cost of the machine Initial Investment
• After-Tax Operating Revenue Flows over time
  Operating Revenues Operating Expenses over many
  periods of time Corporate Income Tax
• Some Savings from Investment itself
• - Tax Shields from CCA over lifetime of the
  machine
• - Sales revenue or Salvage of the scrapped
  machine in the future

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Cash Flow Definitions

• Capital cost allowance (CCA) the depreciation
  claim for tax purposes
• You can deduct this amount your revenues
• Tax savings or Shields Value of the Capital
  times CAA rate times Tax Rate(T)
• Depreciation the economic deterioration of an
  asset as a consequence of its productive life
• Net operating revenue is revenues from
  operations minus all operating expenses excluding
  taxes and CCA deductions

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Cash Flow Calculations Different yet
Equivalent Ways

• Alternative 2
• Net operating revenue
• Less Tax on NOR After-tax NO revenue
• Add Tax savings from CCA
• Net cash flow

Alternative 3 NOR Less Tax on NOR minus CCA Net
Cash flow

• Alternative 1
• Net operating revenue
• Less CCA
• Taxable income
• Less Taxes payable
• Net income or profit
• Add CCA
• Net cash flow

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Assessing Net Present Value

• Net present value (NPV) the sum of all cash
  flows generated by a project with each cash flow
  discounted back to the present
• NPV - initial investment present value of
  after-tax net cash flows PV of tax savings
  PV of salvage
• (-) NPV indicates the projects fall short of
  providing necessary return
• () NPV indicates the projects return is greater
  than the necessary return

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Tax Shields CCA Complications

• Only half of CCA is allowed in the first year
• eg) CCA for the first year is C times d in
  theory.
• However, investment might be made at anytime of
  the year so CCA is C d times 0.5 ,
• tax savings are 0.5 C d times tax rate ( 0.5 C
  d T)
• CCA is calculated on Declining-Balance.
• Each year, CCA is claimed at a constant
  percentage of the remainnig value
• eg) The second year
• the remaining value is CCA C - C d C (1-d)
• CCA is C (1-d) times d
• Tax Savings are C (1-d) times d times T C
  d(1-d) T

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Numerical Exmaple

• Tax rate 0.2 or 20
• Initial Investment 10,000 dollars
• Depreciation rate 0.3 or 30 per annum
• Tax Savings for 1st year 10000 times 0.3
  times 0.2 times 1/2
• Tax Savings for 2nd year 7000 (10000 minus its
  first year depreciation or 3000) times 0.3 times
  0.2
• Tax Savings for 3rd year 4900 (7000 minus
  its second year depreciation or 2100) times 0.3
  times 0.2
• Underlined is CCA or deprecitaion for each year.

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Declining-Balance vs. Straight-Line

• Book Value as a Function of Time

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Present Value of Tax Shields

• Present value of tax shields from
  declining-balance CCA is equal to
• 0.5 C d T/(1k) C (1-d)d T/(1k)2 C(1-d)2 d
  T/(1k)3 ..
• Where
• C capital cost of the asset d rate of
  capital cost allowance T corporate tax rate k
  discount rate

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Present Value of Salvage Value

• If an asset is expected to be sold at the end of
  n years for Sn the salvage value is deducted
  from the UCC of the asset class at the time of
  disposition
• The present value of lost CCA tax shield due to
  salvage value is equal to

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Net Present Value (NPV)

• Grand Formula 1(10.3) on Page 360 of the
  textbook
• () NPV accept project
• (-) NPV reject project

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10.4 Evaluating Projects

• Methods of evaluating projects include
• Net present value (NPV)
• Internal rate of return (IRR)
• Profitability index

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Internal Rate of Return (IRR)

• Internal rate of return (IRR) is the rate of
  discount that when applied to the cash flows of
  an investment, will yield an NPV of zero

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Discounted Cash Flow (DCF) Criteria

• Strengths of DCF are that they
• Tie control over the disbursement of funds to the
  condition under which funds have to be procured
• Can be related directly to the goal of maximizing
  shareholder wealth
• Limitations of DCF are that they
• Ignore the potentially negative impact that
  investments may have on financial statements
• Ignore non- economic aspects that may be
  important

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Abandoning Projects

• An important contribution to the success of a
  firm is the periodical reappraisal of projects to
  determine whether they should be continued or
  whether it is necessary to abandon certain
  projects.

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Summary

• 1. The NPV of a project is defined as the present
  value of all cash flows discounted at the firms
  cost of capital. It measures the economic gain to
  be derived over and above the costs of financing
  a project.
• 2. In evaluating new projects, we are concerned
  with identifying marginal, after-tax cash flows
  excluding any financial charges.

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Summary

• 3. Proper identification of cash flows include
  the choice of an appropriate time horizon, and
  the incorporation of anticipated price-level
  changes. The effects on operating profits and
  net profits stem are viewed from this context.
• 4. The IRR measures the effective yield of a
  project, which is then compared to the cost of
  funding the investment. It relies on the concepts
  of discounting and explicitly recognizes the time
  value of money.

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Summary

• 5. IRR differs from net present value in only the
  way a problem is analysed. Both criteria usually
  produce the same investment decisions.
• 6. The purpose of discounted cash flow criteria
  is to measure economic gain. They may ignore
  other non-economic objectives that a firm may
  have as well as short-run effects of new
  investments on reported financial statements, in
  particular on reported earnings.