Class Eight, July 21st, Capital Budgeting Problems an Introduction
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Transcript of 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