1. Copyright © 2003 Pearson Education Canada Inc. Slide 22-214 Chapter 22 Capital Budgeting: A Closer Look

2. Copyright © 2003 Pearson Education Canada Inc. Slide 22-215 Income Taxes and Capital Budgeting Income taxes are cash disbursements which impact on cash flows Always consider the marginal tax rate or the rate paid on any additional amounts of pretax income Consider operating cash flows on a after-tax basis: After-tax savings = $6,000 x (1 - tax rate of 40%) = $3,600 Page 810 With $6,000 CurrentSavingDifference Revenues$100,000$100,000$0 Expenses70,00064,0006,000 Net income before tax30,00036,0006,000 tax (40%)12,000 9,6002,400 Net income after tax$28,000$24,400$3,600

3. Copyright © 2003 Pearson Education Canada Inc. Slide 22-216 Capital Cost Allowance Federal Income Tax Act (ITA) does not permit a company to deduct amortization (depreciation) in determining taxable income ITA does allow companies to deduct capital cost allowance (CCA) which is similar to amortization ITA assigns assets to specific CCA classes Undepreciated Capital Cost (UCC) correspond to Net Book Value in accounting terms ITA limits the rate of CCA to be half of the regular rate in the first year for most assets (half-year rule) Pages 811 - 812

4. Copyright © 2003 Pearson Education Canada Inc. Slide 22-217 Capital Cost Allowance (CCA) Classes Class 14%Buildings acquired after 1987 Class 820%Capital property, machinery and equipment not included in other classes Class 1030%Automotive equipment, electronic data processing equipment Class 12100%Software, tools costing less than $200 Class 39Manufacturing and processing equipment acquired after 1987 (40%, 35%, 30%, 25%) Page 830

5. Copyright © 2003 Pearson Education Canada Inc. Slide 22-218 CCA Calculations CCA is similar to declining balance amortization Cash saving on taxes (tax shield) due to the deductibility of CCA = CCA x tax rate % Present value d 2 + k of tax savingsd + k2 ( 1 + k) Where: C = investment, t = tax rate, d = CCA rate, k = required rate of return Present value of tax savings =$2,548 = Pages 811 - 812 = $10,000 x 40% 20% 20% + 10% 2 + 10% 2 (1 + 10%) xxC x t xx

6. Copyright © 2003 Pearson Education Canada Inc. Slide 22-219 CCA Table BeginningAdditionsNetCCACCAEnding YearBalanceDisposalBalanceRateAmountBalance 1$0$10,000$10,00010%$1,000$9,000 29,0009,00020%1,8007,200 37,2007,20020%1,4405,760 45,7605,76020%1,1524,608 54,6084,60820%9223,686 63,6863,68620%7372,949 72,9492,94920%5902,359 82,3592,35920%4721,887 91,8871,88720%3771,510 101,5101,51020%3021,208 111,2081,20820%242966 1296696620%193773 Pages 811 - 812

7. Copyright © 2003 Pearson Education Canada Inc. Slide 22-220 Trade-ins and Disposal of Capital Assets CCA system works on a pool basis If buy a new asset for $12,000 with a $4,000 trade-in, add $8,000 to the pool Undepreciated capital cost (UCC) is the balance of CCA remaining on the books at any point in time UCC is equivalent to “net book value” in financial accounting Ignore the UCC balance in the pool for the capital asset that was traded in Note that the half-year rule does not apply to CCA calculations when capital assets are sold Pages 813 - 814

8. Copyright © 2003 Pearson Education Canada Inc. Slide 22-221 Capital Budgeting and Inflation Inflation is the decline in the general purchasing power of the monetary unit Normal, expected inflation is included in the nominal (or normal) required rate of return Include inflation in capital budgeting model if significant over the life of the project Nominal Approach: predict cash inflows and outflows in nominal monetary units and use a nominal rate as the required rate of return Real Approach: predict cash inflows and outflows in real monetary units and use a real rate as the required rate of return Pages 820 - 823

9. Copyright © 2003 Pearson Education Canada Inc. Slide 22-222 Project Risk and Required Rate of Return Organizations typically use at least one of the following approaches in dealing with project risk 1.Varying the required payback time (higher the risk, the shorter the desired payback time) 2.Adjusting the required rate of return (use a higher required rate for risky projects) 3.Adjusting the estimated future cash inflows (reduce cash flows for riskier projects) 4.Sensitivity (what-if) analysis 5.Probability distributions (to account for uncertainty) Pages 824 - 825