1. Chapter McGraw-Hill Ryerson © 2013 McGraw-Hill Ryerson Limited Making Capital Investment Decisions Prepared by Anne Inglis Edited by William Rentz 10

2. 10-1 Key Concepts and Skills Understand how to determine the relevant cash flows for a proposed project Know how to forecast the cash flows and determine if a project is acceptable Understand the various methods for computing operating cash flow Be able to compute the CCA tax shield Know how to evaluate cost-cutting proposals Be able to analyze replacement decisions Understand how to evaluate the equivalent annual annuity or EAA of a project Know how to set a bid price for a project © 2013 McGraw-Hill Ryerson Limited

3. 10-2 Chapter Outline Project Cash Flows: A First Look Incremental Cash Flows Pro Forma Financial Statements and Project Cash Flows More on Project Cash Flow Alternative Definitions of Operating Cash Flow Applying the Tax Shield Approach to the Majestic Mulch and Compost Company Project Some Special Cases of Cash Flow Analysis Summary and Conclusions © 2013 McGraw-Hill Ryerson Limited

4. 10-3 Relevant Cash Flows 10.1 The cash flows that should be included in a capital budgeting analysis are those that will only occur (or NOT occur) if the project is accepted These cash flows are called incremental cash flows The stand-alone principle allows us to analyze each project in isolation from the firm by simply focusing on incremental cash flows LO1 © 2013 McGraw-Hill Ryerson Limited

5. 10-4 Asking the Right Question You should always ask yourself “Will this cash flow occur (or NOT occur) ONLY if we accept the project?” If the answer is “YES”, it should be included in the analysis because it is incremental If the answer is “NO”, it should NOT be included because it will occur anyway If the answer is “PART OF IT”, then we should include the part that occurs (or does NOT occur) because of the project LO1 © 2013 McGraw-Hill Ryerson Limited

6. 10-5 Common Types of Cash Flows 10.2 Sunk costs – prior cost commitments Opportunity costs – costs of lost options Side effects Positive side effects – benefits to other projects Negative side effects – costs to other projects Changes in net working capital Financing costs Effect of Inflation Effect of Government Intervention Capital Cost Allowance (CCA) LO1 © 2013 McGraw-Hill Ryerson Limited

7. 10-6 Pro Forma Statements and Cash Flow 10.3 Capital budgeting relies heavily on pro forma accounting statements, particularly statements of comprehensive income Computing cash flows – refresher Operating Cash Flow (OCF) = EBIT + Depreciation – Taxes = Sales – Costs – Taxes Cash Flow From Assets (CFFA) = OCF – Net capital spending (NCS) – changes in NWC LO2 © 2013 McGraw-Hill Ryerson Limited

8. 10-7 More on NWC 10.4 Why do we have to consider changes in NWC separately? IFRS requires that sales be recorded on the statement of comprehensive income when made, NOT when cash is received IFRS also requires that we record cost of goods sold when the corresponding sales are made, regardless of whether we have actually paid our suppliers yet LO1 © 2013 McGraw-Hill Ryerson Limited

9. 10-8 More on NWC 10.4 (continued) Why do we have to consider changes in NWC separately? Since some sales are credit sales, we must invest in AR for the credit sales. Hence, we must INCREASE NWC due to increased AR. We must buy inventory to support sales, and suppliers often must be paid before sales are made. Thus, an INCREASE in INVENTORY also INCREASES NWC. AP may increase as inventory increases. An INCREASE in AP will DECREASE NWC. LO1 © 2013 McGraw-Hill Ryerson Limited

10. 10-9 Capital Cost Allowance (CCA) CCA is depreciation for tax purposes. The depreciation expense used for capital budgeting should be calculated according to the CCA schedule dictated by the tax code. Depreciation itself is a non-cash expense. Consequently, it is only relevant because it affects taxes. Depreciation tax shield = DT D = depreciation expense T = marginal tax rate LO4 © 2013 McGraw-Hill Ryerson Limited

11. 10-10 Computing Depreciation Need to know which asset class is appropriate for tax purposes Straight-line depreciation D = (Initial cost – salvage) / number of years Very few assets are depreciated straight-line for tax purposes in Canada Declining Balance Multiply percentage given in CCA table by the un- depreciated capital cost (UCC) Half-year rule LO4 © 2013 McGraw-Hill Ryerson Limited

12. 10-11 Methods for Computing OCF 10.5 Bottom-Up Approach Works only when there is NO interest expense OCF = NI + depreciation Top-Down Approach OCF = Sales – Costs – Taxes Don’t subtract non-cash deductions Tax Shield Approach OCF = (Sales – Costs)(1 – T) + Depreciation x T LO3 © 2013 McGraw-Hill Ryerson Limited

13. 10-12 Top-Down vs. Tax Shield Approaches Top-Down Approach OCF = Sales – Costs – Taxes* Tax Shield Approach OCF = (Sales – Costs)(1 – T) + Depreciation x T *Taxes = (Sales – Costs) x T – Depreciation x T Taxes = (Sales – Costs – Depreciation) x T LO3 © 2013 McGraw-Hill Ryerson Limited

14. 10-13 Salvage Value versus UCC 10.6 Using the methods described in the previous slide will give incorrect answers when the salvage value differs from its UCC To correct for this problem, one must account for the tax shields in all of the years after the economic life of the asset The formula below gives the PV at the end of the economic life of the asset for these tax shields LO4 © 2013 McGraw-Hill Ryerson Limited

15. 10-14 Example: Cost Cutting 10.7 A new production system costs $1 million It saves $300,000 a year in inventory and receivables management costs The CCA rate for the system is 20% The salvage value is $50,000 in 5 years There is NO impact on NWC The marginal tax rate is 40% The required return is 8% LO5 © 2013 McGraw-Hill Ryerson Limited

16. 10-15 Cash Flow Analysis Approach: Yearly Tax Shields BeginCCAEnd YearUCC CCATax ShieldUCC 1$1,000,000$100,000*$40,000$900,000 2$ 900,000$180,000$72,000 $720,000 3$ 720,000$144,000$57,600$576,000 4$ 576,000$115,200$46,080$460,080 5$ 460,800$ 92,160$36,864$368,640 * ½ year convention applies the first year LO5 © 2013 McGraw-Hill Ryerson Limited

17. 10-16 Cash Flow Analysis Approach: Tax Shields After Year 5 (UCC n – S) remains on the books Creates CCA tax shields in yrs (n + 1) thru ∞ At time n, what is the PV of these shields? LO5 © 2013 McGraw-Hill Ryerson Limited

18. 10-17 Cash Flow Analysis Approach: Yearly Cash Flows for Yrs 0 - 2 LO5 © 2013 McGraw-Hill Ryerson Limited

19. 10-18 Cash Flow Analysis Approach: Yearly Cash Flows for Yrs 3 - 5 LO5 © 2013 McGraw-Hill Ryerson Limited

20. 10-19 Cash Flow Analysis Approach: Calculate the NPV LO5 © 2013 McGraw-Hill Ryerson Limited

21. 10-20 PV of CCA Tax Shield Formula Where: I = Total Capital Investment d = CCA rate Tc = Corporate Tax Rate k = discount rate S n = Salvage value in year n n = number of periods in the project LO4 © 2013 McGraw-Hill Ryerson Limited

22. 10-21 CCA Formula Approach Step 1: Calculate the PV of after-tax net revenues LO5 © 2013 McGraw-Hill Ryerson Limited

23. 10-22 CCA Formula Approach Step 2A: PV of CCA tax shields from investment I Step 2B: PV of CCA tax shields lost due to S n LO5 © 2013 McGraw-Hill Ryerson Limited

24. 10-23 CCA Formula Approach Step 3: PV of salvage value S n Step 4: PV of NWC effects for Years 1 thru n LO5 © 2013 McGraw-Hill Ryerson Limited

25. 10-24 CCA Formula Approach Step 5: Subtract initial outlay LO5 © 2013 McGraw-Hill Ryerson Limited

26. 10-25 CCA Formula Approach: Calculate the NPV Step 1: + $ 718,687.81 Step 2A: + $ 275,132.28 Step 2B: - $ 9,722.62 Step 3: + $ 34,029.16 Step 4: - $ 0.00 Step 5: - $1,000,000.00 NPV = + $ 18,126.63 1¢ discrepancy due to rounding intermediate steps to nearest 1¢ LO5 © 2013 McGraw-Hill Ryerson Limited

27. 10-26 Equivalence of CCA Tax Shields PV of Cash Flow Analysis CCA Tax Shields PV of CCA Formula Tax Shields Step 2A: + $275,132.28 Step 2B: - $ 9,722.62 PV = + $265,409.66 LO5 © 2013 McGraw-Hill Ryerson Limited

28. 10-27 Example: Replacement Problem Original Machine Initial cost = 100,000 CCA rate = 20% Purchased 5 years ago Salvage today = 65,000 Salvage in 5 years = 10,000 New Machine Initial cost = 150,000 5-year life Salvage in 5 years = 0 Cost savings = 50,000 per year CCA rate = 20% Required return = 10% Tax rate = 40% LO6 © 2013 McGraw-Hill Ryerson Limited

29. 10-28 Example: Replacement Problem continued Remember that we are interested in incremental cash flows If we buy the new machine, then we will sell the old machine What are the cash flow consequences of selling the old machine today instead of in 5 years? LO6 © 2013 McGraw-Hill Ryerson Limited

30. 10-29 Example: Replacement Problem continued If we sell the old equipment today, then we will receive $65,000 today. However, we will also NOT receive $10,000 in 5 years The appropriate number to use in the NPV analysis is the NET salvage value Always consider after-tax cash flows You can use your calculator for the cash flows and salvage, but there are NO short cuts for finding the PV of the CCA tax shield LO6 © 2013 McGraw-Hill Ryerson Limited

31. 10-30 Example: Replacement Problem continued Net present value of the project is: Therefore, the old equipment should be replaced because NPV > 0. LO6 © 2013 McGraw-Hill Ryerson Limited

32. 10-31 Example: Equivalent Annual Annuity Machine A Initial Cost = $150,000 Pre-tax revenues = $120,000 Pre-tax operating cost = $65,000 Expected life is 8 years Machine B Initial Cost = $100,000 Pre-tax revenues = $90,000 Pre-tax operating cost = $40,000 Expected life is 6 years No change in NWC and no salvage value for either asset The required return is 10%, the applicable CCA rate is 20% and the tax rate is 40%. Which machine should you buy? LO7 © 2013 McGraw-Hill Ryerson Limited

33. 10-32 Which Machine? Which machine should you buy? This depends on which scenario you are facing. Scenario 1: Machines are independent projects. Scenario 2: Machines are mutually exclusive projects that can NOT be repeated. Scenario 3: Machines are mutually exclusive projects that can be repeated indefinitely. LO7 © 2013 McGraw-Hill Ryerson Limited

34. 10-33 Calculate NPV of Two Machines LO7 © 2013 McGraw-Hill Ryerson Limited

35. 10-34 Which Machine? LO7 © 2013 McGraw-Hill Ryerson Limited Scenario 1: Independent projects Buy both machines as both have NPV > 0 Scenario 2: Mutually exclusive, non-repeating Buy Machine A as NPV A > NPV B & NPV A > 0 Scenario 3: Mutually exclusive, repeating forever Need to calculate the EAA or EANPV for both machines and pick the higher EAA

36. 10-35 Calculate Equivalent Annual Annuity LO7 © 2013 McGraw-Hill Ryerson Limited

37. 10-36 Which Machine in Scenario 3? LO7 © 2013 McGraw-Hill Ryerson Limited Scenario 3: Mutually exclusive, repeating forever Buy Machine B since EAA B > EAA A & EAA B > 0 What is the rationale for this decision? If you repeatedly replace a machine with an identical one, then the cash flows over the infinite horizon are equivalent to a perpetuity equal to the equivalent annual annuity or EAA. The NPV over an infinite horizon is then EAA/k!

38. 10-37 Equivalent Annual Cost (EAC) LO7 © 2013 McGraw-Hill Ryerson Limited A special case of the EAA calculation occurs when the revenues are the same for both machines In this case, we can ignore the revenues and focus on only the costs and calculate the net present cost or NPC for each machine Then one calculates the EAC for each machine and picks the one with lower EAC

39. 10-38 Example: Setting the Bid Price Consider the example in the textbook: Need to produce 5 modified trucks per year for 4 years We can buy the truck platforms for $10,000 each Facilities will be leased for $24,000 per year Labour and material costs are $4,000 per truck Need $60,000 investment in new equipment, depreciated at 20% (CCA class 8) Expect to sell equipment for $5,000 at the end of 4 years Need $40,000 in net working capital Tax rate is 43.5% Required return is 20% LO8 © 2013 McGraw-Hill Ryerson Limited

40. 10-39 Bid Price: CCA Formula Approach Step 1: Calculate the PV of after-tax net revenues Step 2A: PV of CCA tax shields from investment I LO5 © 2013 McGraw-Hill Ryerson Limited

41. 10-40 Bid Price: CCA Formula Approach Step 2B: PV of tax shields lost due to S n Step 3: PV of salvage value S n LO5 © 2013 McGraw-Hill Ryerson Limited

42. 10-41 Bid Price: CCA Formula Approach Step 4: PV of NWC effects for Years 1 - 4 Step 5: Subtract initial outlay LO5 © 2013 McGraw-Hill Ryerson Limited

43. 10-42 Bid Price Based on NPV = 0 NPV = 7.31317515P - $137,487.69 + $11,962.50 - $524.45 + $2,411.27 + $19,290.12 - $100,000 = 0 7.31317515P = $204,348.25 or P = $27,942.48 The firm must bid at LEAST $27,942.48 to recover its required return on invested capital. LO5 © 2013 McGraw-Hill Ryerson Limited

44. 10-43 Quick Quiz How do we determine if cash flows are relevant to the capital budgeting decision? What are the different methods for computing operating cash flow and when are they important? What is the basic process for finding the bid price? What is equivalent annual cost and when should it be used? © 2013 McGraw-Hill Ryerson Limited

45. 10-44 Summary 10.8 You should know: How to determine the relevant incremental cash flows that should be considered in capital budgeting decisions How to calculate the CCA tax shield for a given investment How to perform a capital budgeting analysis for: Replacement problems Cost cutting problems Bid setting problems Projects of different lives © 2013 McGraw-Hill Ryerson Limited

46. © 2014 Dr. William F. Rentz & Associates Additions, deletions, and corrections to these transparencies were performed by Dr. William F. Rentz solely for use at the University of Ottawa. The above copyright notice applies to all changes made herein. 10-45