1. Capital Budgeting Decisions10
Capital Budgeting Decisions

2. Capital Budgeting
Long-term planning for making and financing acquisitions
Three phases 1. identify potential investments
2. select investments to undertake
3. follow-up monitoring (post-audit)
Discounted-Cash-Flow Model
Evaluate long-term investments using the time value of money
Focuses on cash inflows and outflows rather than net income
Two Approaches
Net present value (NPV)
Discount all expected future
cash flows to the present using a minimum desired rate of return
Accept project if NPV > 0
Internal rate of return (IRR)
Determine the rate of return which will result in a NPV of zero
Accept project if IRR > minimum desired rate of return

3. Net Present Value Present Total End of Year Cash Flows
Value of $1 Present
@ 10% Value
Cash flows:
annual savings $1,818 $2,000
,653 $2,000
, $2,000
, $2,000
Present value
of future inflows $6,340
Initial outlay (6,075) (6,075)
Net present value $ 265
Using Annuity Table
Annual savings $6,340 $2,000 $2,000 $2,000 $2,000
Initial outlay (6,075) (6,075)

4. Internal Rate of Return
Present Total End of Year Cash Flows
Value of $1 Present
@ 12% Value
Cash flows:
annual savings $1,786 $2,000
,594 $2,000
, $2,000
, $2,000
Present value
of future inflows $6,075
Initial outlay (6,075) (6,075)
Net present value $
Using Annuity Table
Annual savings $6,075 $2,000 $2,000 $2,000 $2,000
Initial outlay (6,075) (6,075)
Net present value $

5. Using DCF Models Limitations of using the discounted cash flow model
Certainty of predicted cash flows
Perfect capital markets
Never include depreciation or amortization (a non-cash expense) when determining NPV or IRR.
Cash flow related to the acquisition of equipment occurs as a lump-sum outflow at the time of purchase

6. Choosing the Minimum Desired Rate of Return
Always keep the investment and financing decisions separate investment decision - focus on whether to acquire an asset
Financing decision - focus on whether to acquire cash by issuing debt or equity or some combination of the two
Do not include financing (interest) costs in NPV or IRR model as interest costs are already included in the discount rate
Most non-profit organizations employ a minimum desired rate of return which approximates long-term debt rates

7. Other Capital Budgeting Models I
Payback
Length of time required to recoup, in the form of cash flows from operations, the initial outlay
Payback = initial incremental investment
time equal annual incremental cash flow
= $10,000 / $4,000 per year
= 2.5 years
Fails to consider the "profitability" of the project

8. Other Capital Budgeting Models II
Accounting Rate-of-Return
Annual rate of return including depreciation or amortization expenses
Also known as accrual accounting rate-of-return model or the unadjusted rate-of-return model
Increase in expected
Accounting = expected average annual operating income
rate of return initial increase in required investment
Can also use average book value of fixed assets as the denominator
Major drawback is that it ignores the time value of money

9. Income Taxes and Capital Budgeting
Depreciation (or amortization) does not require an outlay of cash as cash was given up when the asset was purchased
Depreciation (or amortization) is the systematic allocation of the cost of the asset over its estimated (useful) life
Depreciation (or amortization) is a deductible expense in computing income; it reduces taxable income and the cash flow required to cover taxes payable
When performing capital budgeting analysis, always consider after-tax flows

10. After-Tax Cash Flow Formulas
After-tax cash outflow from a cash outlay
= cash outlay x (1 - tax rate)
After-tax cash inflow from a cash receipt
= cash receipt x (1 - tax rate)
After-tax cash inflow from a non-cash expense
= non-cash expense x tax rate
After-tax cash outflow from a non-cash revenue
= non-cash revenue x tax rate

11. Capital Cost Allowance
Federal Income Tax Act (ITA) does not allow a company to deduct depreciation (or amortization) in determining taxable income
It does however allow for Capital Cost Allowance (CCA) which is the income tax counterpart to depreciation
ITA assigns all assets to specific CCA classes

12. Capital Cost Allowance and The Half-Year Rule
Calculate CCA following declining-balance method
”Half-year rule" - rate of CCA is reduced by one-half in the year of acquisition
Beginning Additions Net CCA CCA Ending
Year Balance Deletion Balance Rate Amount Balance
1 $0 $10,000 $10,000 10% $1,000 $9,000
2 $9,000 $0 $9,000 20% $1,800 $7,200
3 $7,200 $0 $7,200 20% $1,440 $5,760
4 $5,760 $0 $5,760 20% $1,152 $4,608
5 $4,608 $0 $4,608 20% $922 $3,686
6 $3,686 $0 $3,686 20% $737 $2,949

13. Tax Shield From Capital Cost Allowance
Tax shield is the amount of cash saved on income taxes due to the deductibility of capital cost allowance
Total savings can be discounted to the present time using the following tax shield formula
Present value of tax savings
where k = required rate of return
Example: $10,000 desk, Class 8 (20%), 40% tax rate,
10% required rate of return
= { $10,000 x .40 } x { .20 / ( )} x { 2.10 / 2.20 }
= $4,000 x .667 x .955
= $2,668 x .955
= $2,548

14. Trade-Ins and Disposals of Capital Assets
Undepreciated capital cost (UCC)
Net tax book value of an asset
Capital cost allowance calculations ignore the net UCC of the asset when a capital asset is traded-in on another asset or is sold
CCA works on a pool basis so that we do not have to be concerned with the UCC of the specific asset being disposed of
Note that the half-year rule does not apply to CCA calculations when assets are sold

15. Trade-Ins and Disposals of Capital Assets (con’d)
Example:
Trade-in old desk with a remaining UCC of $5,760 at the end of year 3 for a new desk costing $12,000 with a trade-in allowance of $4,000
New shield on new desk
= { $8,000 x .40 } x { .20 / ( )} x {2.10 / 2.20} = $2,038
Tax shield lost on disposal of old desk
= { $4,000 x .40 } x { .20 / ( )} = $1,067

16. Capital Budgeting and Inflation
Inflation is the decline in the general purchasing power of the monetary unit
Include in capital budgeting model if significant over the life of the project under consideration
Example
An investment is expected to save $50,000 after taxes per year
[$83,333 x (1 - 40%)] for 5 years; 3% inflation; 15% discount rate
After-tax Inflation Adjusted PV factor Present
Year Saving Adjustment 15% Value
1 $50, $51, $44,784
2 50, , ,107
3 50, , ,923
4 50, , ,178
5 50, , ,820
$181,812

17. Capital Investment and Risk
Risk occurs because the actual cash flows may differ from what is expected
With capital budgeting, need to first determine the riskiness of the investment
Next, the inputs t o the capital budgeting model should be adjusted to reflect the risk

18. Recognizing Risk Three common ways:
1. Reduce individual expected cash inflows or
increase or increase expected cash outflows by
an amount that depends on their riskiness
2. Reduce the expected life of riskier projects
3. Increase the minimum desired rate of return for
riskier projects

19. Capital Investments and Sensitivity Analysis
Shows the financial consequences that would occur if actual cash inflows and outflows differed from those expected
Two types:
1. comparing the optimistic, pessimistic, and
most likely predictions
2. determining the amount of deviation from
expected values before a decision is
changed