1. ©2012 McGraw-Hill Ryerson Limited 1 of 45 Learning Objectives 4.Appraise the use of the cost of capital as the discount rate in capital budgeting analysis. (LO4) 5.Integrate the cash flows that result from an investment decision, including the after tax operating benefits and the tax shield benefits of capital cost allowance (amortization). (LO5) 6.Perform NPV analysis to assist in the decision- making process concerning long-run investments. (LO6)

2. ©2012 McGraw-Hill Ryerson Limited 2 of 45 Making Investment Decisions When estimating cash flows for an investment proposal, remember that only those cash flows resulting from the potential acceptance decision are relevant and should be included in your estimation. For example, a proposal of purchasing a new van to replace an old van should only include the net cost of the new van, that is, the difference between the cost of the new van and the sale price of the old van. The present value of CCA tax shield = LO6

3. ©2012 McGraw-Hill Ryerson Limited 3 of 45 Table 12-13 Net present value of resultant cash flows at 12% LO6 Investment in Vans YearCash FlowAmount(1 – t) Aftertax Cash Flow Present Value 0Purchase vans-$30,000----$30,000 0Sell old van500---500 1-4Operating17,0000.61$10,37031,497 4Salvage4,000---2,542 Present value of CCA tax shields ($30,000 - $500 - $2,542) (0.263647)*7,107 Net present value of resultant cash flows and initial investment$11,646 *This number is from our calculation using formula 12-1

4. ©2012 McGraw-Hill Ryerson Limited 4 of 45 Table 12-14 IRR solution framework using 25% LO6 Investment in Vans YearCash FlowAmount(1 – t) Aftertax Cash Flow Present Value 0Purchase vans-$30,000----$30,000 0Sell old van500---500 1-4Operating17,0000.61$10,37024,490 4Salvage4,000---1,638 Present value of CCA tax shields ($30,000 - $500 - $1,638) (0.30) (0.39) (1 + 0.5(0.25) 0.25 + 0.30 1 + 0.25 5,334 = $27,862 (0.212727) (0.90) Net present value of resultant cash flows and initial investment$1,962

5. ©2012 McGraw-Hill Ryerson Limited 5 of 45 Making Investment Decisions To make the actual investment decision: 1)determine the net cash outflow arising from the initial investment 2)estimate the amounts and timing of net future cash inflows (aftertax) 3)discount the future cash flows back to the present 4)add the present value of the Capital Cost Allowance shield, using the formula and appropriate CCA rate 5)determine whether the machine should be purchased (if NPV > 0) LO6

6. ©2012 McGraw-Hill Ryerson Limited 6 of 45 Table 12-15 Net price of the new computer Price of the new computer........................ $150,000 - Investment tax credit (15%) or $22,500............. 19,737* Net price of new computer........................ 130,263 - Cash inflow from sale of old computer............. 40,000 Net cost of new computer......................... $ 90,263 * Our assumption about cash flows (revenues, expenses) and tax-initiated cash flows is that they occur at the end of the year. Therefore, the tax credit of $22,500 is discounted one year. The CCA pool is affected in the year after acquisition. The CCA tax shield formula is constructed assuming tax savings effects occur at the end of the year. LO6

7. ©2012 McGraw-Hill Ryerson Limited 7 of 45 Table 12-16 Differential analysis of new computer LO6 YearCash FlowAmount(1 – Tax rate) Aftertax Cash Flow Present Value (@ 14%) 0New computer-$90,263--- -$90,263 0Working capital investment -5,000--- -5,000 1Cost savings20,0000.6112,200 10,702 2Cost savings38,0000.6123,180 17,836 3Cost savings40,0000.6124,400 16,469 4Cost savings45,0000.6127,450 16,253 5Cost savings45,0000.6127,450 14,257* 5Salvage30,000--- 15,581 0Working capital recovery5,000--- 2,597 Present value of CCA tax shield benefits … (from calculation) 20,490 Net present value$18,922 *The present value of all the cost savings may be handled in one output from the calculator, particularly if it is an annuity.

8. ©2012 McGraw-Hill Ryerson Limited 8 of 45 Discounted Cash Flows Models – The Difficulties Both NPV and IRR models require the estimation of future expected cash flows and the selection of an appropriate opportunity cost of capital. There can be difficulties and mistakes estimating future cash flows. Also bias in estimates based by managers who wish to see their project accepted. Despite the use of models to determine the discount rate, its determination is a judgement call. LO6