cc ch 22 capital budgeting and a closer look

8/12/2019 Cc Ch 22 Capital Budgeting and a Closer Look

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General Characteristics

Income taxes are cash disbursements and therefore an important cash flow consid-eration. Income taxes almost always influence the amount and/or the timing of cashflows. Their basic role in capital budgeting is no different from that of any othercash disbursement. Payment of income tax tends to narrow the cash differencesbetween projects.

The Canadian federal and provincial governments raise money through corpo-

rate income taxes. Income tax rates differ considerably, and thus, overall corporateincome tax rates can vary widely.

Income tax rates also depend on the amount of pretax income. Larger incomeis taxed at higher rates. In capital budgeting, the relevant rate is the marginalincome tax rate, that is, the tax rate paid on additional amounts of pretax income.Suppose corporations pay income taxes of 15% on the first $50,000 of pretax incomeand 30% on pretax income over $50,000. What is the marginal income tax rate of acompany with $75,000 of pretax income? It is 30%, because 30% of any additional income over $50,000 will be paid in taxes. In contrast, the company’s average incometax rate is only 20% (i.e., 15% $50,000 30% $25,000 $15,000 $75,000of pretax income). When we assess tax effects of capital budgeting decisions, we willalways use the marginal tax rate. Why? Because that is the rate applied to the addi-tional cash flows generated by a proposed project.

Organizations that pay income taxes report their net income to the publicusing the CICA standards as they must in order to obtain a clean audit opinion. These standards allow managers to choose among amortization methods and whennecessary change from one method to another. The amortization expense deducted would affect taxable income, something the Canadian Revenue Agency (CRA) doesnot permit. This is why governments have created laws that, for purposes of payingtax, require corporations to deduct capital cost allowance (CCA) when calculatingtheir taxable income. Legally, the taxable income reported to CRA on a confidentialbasis differs from mandatory public disclosure under CICA standards. This meansthat the tax expense on the statement of income, an accrual, will differ from the cashtax paid to the government. The difference between the accrual and the cash flow amounts accumulates as future tax liabilities, which will eventually be paid. This

means that the CCA that affects cash flow in the form of corporate income taxpaid each year is relevant to assessing investment projects. Amortization, however,is not. In this chapter we are concerned with effects on the cash outflows fortaxes. Therefore, we focus on the tax reporting rules, not those for public financialreporting.

848 CHAPTER 22

Income Taxes and Capital Budgeting

Marginal income tax rate. The taxrate paid on any additional amountsof pretax income.

Department of Finance CanadaGlossarywww.fin.gc.ca/gloss/gloss-s_e.html

Tax Impact on Operating Cash Flows

Recognizing the impact of income taxes on operating cash flows is straightforward.If a capital proposal results in a reduction in costs, for example, an annual cost saving of $60,000, then the company’s taxable income will increase by $60,000all other things being equal. If the company has a marginal tax rate of 40%, thenthe company’s income taxes will increase by $24,000 ($60,000 0.40). A net annual after-tax savings of $36,000 results ($60,000 $24,000). This means theafter-tax savings can be calculated quickly as $60,000 (1 minus the tax rate) or$60,000 0.60 $36,000.

If operating expenses increase by $250,000, then the taxable income willdecrease by $250,000. If the company has a 40% marginal tax rate, then thetax saving will be $100,000 ($250,000 0.40). An after-tax cost increaseof $150,000 results [$250,000 (1 0.40)]. Thus, to incorporate the impact of income taxes on operating cash flows poses no real difficulty. The difficulty occurs in the recognition of the tax effects of investment expenditures in capitalequipment.

O B J E C T I V E 1

Analyze the impact of

income taxes on operatingcash flows



In financial reporting, the expenditure on capital equipment results in the recordingof the asset and the related amortization expense over the asset’s useful economiclife. Amortization rates and policies are determined by the company’s management and vary from company to company even for the same asset.

To apply a consistent set of regulations and to provide a means to implement government initiatives, the federal government has implemented its own system of capital cost allowance (CCA). The Income Tax Act (ITA) does not permit a com-pany to deduct amortization expense in determining taxable income but rather acompany is allowed to deduct CCA. If you like, CCA is the legally required incometax counterpart to annual amortization expense in financial reporting.

Capital Cost Allowance—Declining Balance Classes

The ITA assigns all capital purchases to a CCA class. (The appendix to this chapterprovides a list of some of the more commonly used CCA classes.) For example, a desk would qualify as a Class 8 asset that includes all furniture and fixtures. Class 8 has apredetermined rate of 20% declining balance capital cost allowance. Exhibit 22-1 onpage 850 depicts the calculation of CCA for a desk that costs $10,000.

A number of years ago, a company could deduct a full year’s worth of CCA onany asset acquired during the year, as long as the company had been in business theentire year. Thus, companies with a December 31 year-end would buy assets on or

about December 31 and claim a full year’s deduction even though the asset had not really been used to generate the income. To minimize this problem, the government implemented the so-called “half-year rule.”

The half-year rule assumes that all net additions are purchased in the middleof the year, and thus only one-half of the stated CCA rate is allowed in the first year. Thus in year 1 of the example in Exhibit 22-1, the CCA is $1,000 or 1/2 times 20%multiplied by the $10,000 capital expenditure. This leaves a balance of $9,000($10,000 $1,000), which is known as the unamortized capital cost (UCC).

In year 2 and all succeeding years, the rate of 20% is applied to the UCC of theprevious year. This results in a declining amount of capital cost allowance for each year. Even after the 25 years shown in Exhibit 22-1, a UCC of $42 remains and willrequire 15 more years to get to a zero balance (which in practice can only beobtained by rounding to the nearest dollar).

The CCA of each year is deducted in the calculation of a company’s taxableincome. Thus, the CCA is not a cash flow. Rather we must multiply the CCA of each year by the company’s marginal tax rate to calculate the actual tax savings in each year. In Chapter 21, we recognized the time value of money. Thus, to determine thepresent value of the tax savings, we would need to multiply the tax savings of each year by the present value factor from Appendix A for each year at the company’srequired rate of return (say 10%).

This, as you could well imagine, would be a long and laborious task to performfor each capital proposal. An efficient way to calculate the present value of the taxsavings is to use the following tax shield formula:

( ) ( )In the case of the $10,000 desk, the present value of the tax savings from deducting

CCA, commonly referred to as the tax shield, is $2,548, computed as follows assuming a10% required rate of return:

Tax shield ($10,000 40%) ( ) ( ) $4,000 0.667 0.955

$2,668 0.955

$2,548

2 10%)

2(1 10%)

20%20% 10%

(2 required rate of return)2 (1 required rate of return)

CCA rate

CCA rate requiredrate of return

Investment

marginal tax rate

Present value

of tax savings

849CAPITAL BUDGETING:

A CLOSER LOOK

Tax Impact on Investment Cash Flows

O B J E C T I V E 2

Analyze the effect of incometaxes on capital cash flowsand compute the after-taxnet present values of projects

Capital cost allowance (CCA).The legally mandatory income taxcounterpart to annual amortizationexpense in financial reporting.

Half-year rule. The assumption, incalculating capital cost allowance, that all net additions to a company’sassets are purchased in the middleof the year, so that only half theapplicable capital cost allowancerate is allowed in the first year.

Unamortized capital cost (UCC).The result of subtracting the capitalcost allowance from the capitalexpenditure or its amortized balance.

Tax shield formula. A formula forcalculating the tax savings fromdeducting capital cost allowance.



cost of the intangible asset. This is termed the eligible capital property . Intangibleassets, by definition, have an indefinite useful life, and the annual deduction is calledthe cumulative eligible capital amount (CECA), calculated at 7% on a declining-balance basis. The balance remaining after deducting CECA is called the cumula-tive eligible capital (CEC) pool.

Tradeins and Disposals of Capital Assets

When a capital asset is traded in on another asset or is sold, we do not need to concernourselves with the net tax book value of the asset.

Assume that a company’s Class 8 UCC for all of its furniture and fixtures is$50,000, as shown in Exhibit 22-2, at the end of year 3. Let us also assume that includedin the $50,000 is the remaining UCC on the desk of $5,760.

If in year 4 the desk was traded in on a new desk, where the price of the new desk is $12,000, and $4,000 was allowed as a tradein, the Class 8 UCC would increaseby $8,000. Note that the CCA system works on a pool basis, in that we are not con-cerned with the UCC of the specific desk being sold. Rather we are only concerned with the net cash flows. The UCC of the class that existed before the disposal is only reduced by the amount of the cash received. Thus, the actual amount of the UCC of the specific asset is irrelevant to the decision. In this example, the net capital expen-diture of $8,000 is the relevant cash flow.

Continuing with the example in Exhibit 22-2, the CCA for year 4 is $10,800. This is a combination of the CCA at the rate of 20% on the opening UCC of $50,000 ($10,000) and the CCA at the half-year rule rate of 10% on the net additionof $8,000 ($800).

Thus, as shown in Exhibit 22-3 on page 852, the net after-tax present value of the cost of the new desk is $5,964. This amount recognizes the fact that the taxshield of $2,036 on the net addition of $8,000 must recognize the half-year rule.

If in the above scenario a new desk had not been purchased, but rather the olddesk was sold for $4,000, the CCA would be 20% of $46,000 or $9,200. Note thehalf-year rule does not apply to net disposals, that is where the amount of disposalsexceeds the amount of additions during a given year.

From Exhibit 22-3, note that the sale of $4,000 reduces the future CCA and resultsin a lost tax shield of $1,067. Thus, the net after-tax present value of the sale is $2,933.

Simplifying AssumptionsIt is useful to note that a number of simplifying assumptions have been made whenusing the tax shield formula:

1. We have assumed that the company’s marginal tax rate will remain the same (at 40% in the above examples). Further, the above examples also assume that thecompany will have a taxable income each year.


A CLOSER LOOK

Eligible capital property. 75% of the acquisition cost of an intangibleasset, and the basis for the annualdeduction permitted by the income tax act.

Cumulative eligible capitalamount (CECA). The statutoryannual deduction permitted onintangible assets; the equivalentof CCA for tangible assets.

Cumulative eligible capital (CEC).The balance remaining afterdeducting CECA; the equivalent ofUCC for tangible assets.

Department of Justice, Canadahttp://laws.justice.gc.ca/en/I-3.3/C.R.C.-c.945/135982.html

O B J E C T I V E 3

Explain the after-tax effect on cash of tradeins anddisposals of assets

EXHIBIT 22-2Tradein of a Capital Asset

CCA—Class 8

Ending UCC —year 3 50,000$

Purchase 12,000

Year 4— CCA

20% $50,000 10,000

Total CCA 10,800

Less: Tradein (4,000)

Net change in UCC 8,000

Revised UCC 58,000

10% $8,000 800

$UCC—year 4 47,200



2. Although it is uncommon, governments can change the CCA rates that wehave assumed to be constant.

3. We have also assumed that all CCA tax savings occur at the year-end. In reality,companies make monthly instalments. However, the additional cost of attempting to be more precise is not warranted, given the degree of uncertainty that already exists in the estimation of the cash flows.

852 CHAPTER 22

EXHIBIT 22-3Net Capital Cash Flow of Tradeins and Disposals

Tradein (4,000)

Net cash payment 8,000

Tax shielda2,036

NPV cash outflow 5,964$Disposal: Sales price 4,000

Lost tax shieldb 1,067NPV cash inflow 2,933$

aIncludes the half-year adjustment:

($8,000 40%)

bExcludes the half-year adjustment

($4,000 40%)

Purchase price 12,000$ Tradein:

20%10%

20%10%

20%

2(110%)

210%

20%

In the foregoing illustrations, we deliberately avoided many possible income taxcomplications. As all taxpaying citizens know, income taxes are affected by many intricacies, including progressive tax rates, loss carrybacks and carryforwards, vary-ing provincial income taxes, capital gains, distinctions between capital assets andother assets, offsets of losses against related gains, exchanges of property of like kind,exempt income, and so forth.

Income Tax Complications

Confusion About Amortization

Keep in mind that changes in the tax law occur each year. Always check the current tax law before calculating the tax consequences of a decision.

The meanings of amortization and book value are widely misunderstood.Pause and consider their role in decisions. Suppose a bank has some printing equip-ment with a book value of $30,000, an expected terminal disposal value of zero, acurrent disposal value of $12,000, and a remaining useful life of three years. For sim-

plicity, assume that straight-line amortization of $10,000 yearly will be taken.In particular, note that the inputs to the decision model are the predicted

income tax effects on cash. The book loss of $18,000 or the amortization of $10,000may be necessary for making predictions. By themselves, however, they are not inputsto DCF decision models.

The following points summarize the role of amortization regarding thereplacement of equipment:

1. Initial investment . The amount paid for (and hence amortization on) old equip-ment is irrelevant except for its effect on tax cash flows. In contrast, the amount paid for new equipment is relevant, because it is an expected future cost that willnot be incurred if replacement is rejected.



2. Do not double-count. The investment in equipment is a one-time outlay at timezero, so it should not be double-counted as an outlay in the form of amortization. Amortization by itself is irrelevant; it is not a cash outlay.

3. Relation to income tax cash flows. Relevant quantities were defined in Chapter 4as expected future data that will differ among alternatives. Given this definition,book values and past amortization are irrelevant in all capital budgeting decisionmodels. The relevant item is the income tax cash effect, not the book value or theamortization.


A CLOSER LOOK

Alternative Approaches to Capital Budgeting

We turn now to a fuller discussion of how income taxes can affect cash inflows and out-flows and also how they influence managers’ decisions. We focus on the information-acquisition and selection stages of capital budgeting, highlight the effect of incometaxes, and use the net present value method for the formal financial analysis.

Example: Potato Supreme produces potato products for sale to supermarkets andother retail outlets. It is considering replacing an old packaging machine (purchasedthree years ago) with a new, more efficient packaging machine that has recently beenintroduced. The new machine is less labour-intensive and has lower operating coststhan the old machine. For simplicity, we assume that

1. All cash outflows or inflows occur at the end of the year (even though cashoperating costs generally occur throughout the year).

2. The tax effects of cash inflows and outflows occur at the same time that theinflows and outflows occur.

3. The income tax rate is 30% each year.

4. The equipment is one of several assets that qualify as CCA Class 8, with a CCA rate of up to 20% declining balance. Potato Supreme takes the maximum rateeach year.

5. Both the old and the new machine have the same working capital requirements.

6. Potato Supreme is a profitable company.

Summary data for the two machines are as follows:

Old Machine New Machine

Original cost $ 87,500 $200,000

Accumulated amortization $ 37,500 —

Current book value $ 50,000 —

Current disposal price $ 26,000 —

Proceeds of disposition, 4 years from now $ 6,000 $ 20,000

Annual cash operating costs $250,000 $150,000

Remaining useful life 4 years 4 years

After-tax required rate of return 10% 10%

Capital cost allowance rate 20% (declining 20% (declining

balance) balance)

Potato Supreme uses the net present value method to evaluate whether it shouldreplace the old with the new packaging machine immediately or in four years’ time. As in the Lifetime Care example of Chapter 21, the key point in net present valueanalysis is to identify the relevant cash flows. To emphasize the ideas of relevance,Chapter 21 used the differential approach , which analyzes only relevant cashflows—those future cash outflows and inflows that differ between alternatives. Thedifferential approach is generally faster when there are only two alternatives.

When the number of alternatives is more than two, the differential approachbecomes unwieldy. Why? Because it forces the analyst into difficult calculations of differences among multiple alternatives. Companies then use the total-project approach.

O B J E C T I V E 4

Distinguish between thetotal-project approach andthe differential approach incapital budgeting decisions

Differential approach. Approach todecision making and capitalbudgeting that analyzes only thosefuture cash outflows and inflows thatdiffer among alternatives.



The total-project approach calculates the present value of all future cash inflowsand outflows under each alternative separately. It does not require the identificationof cash flows that differ among alternatives. The total-project approach has two steps:

◆ Step 1. Calculate the present value of all cash inflows and outflows under thestatus quo alternative.

◆ Step 2. Separately calculate the present value of all cash inflows and outflowsunder another alternative.

We use the Potato Supreme example to illustrate the two steps of the total-project

approach. We then use the differential approach to show that both approaches give thesame net present value. The following categories of cash flows are considered in bothapproaches:

a. Initial machine investment

b. Tax shield on the initial investment

c. Cash flow from current disposal of old machine

d. Lost tax shield from current disposal of machine

e. Recurring after-tax cash operating flows

f. Cash flow from proceeds of disposition of old machine. Other assets remainin this asset class.

g. Lost tax shield from terminal disposal of machine

Total-Project Approach

◆ Step 1: Calculate the present value of total cash flows of replacing the old packaging machine in four years’ time. Under this alternative, cash flow categories that specifically pertain to the new machine are not relevant. But the purchase priceis relevant when calculating item g, the lost tax shield. If the purchase priceof new equipment exceeds proceeds of disposition of the old equipment,net addition , the half-year rule applies.

a. Initial machine investment. No new investment is necessary if Potato Supremekeeps the old packaging machine. Exhibit 22-4, item a, shows an initialmachine investment of $0 in year 0.

b. Tax shield on initial investment . As there is no new investment, there is then no

additional tax shield.c. Cash flow from current disposal of old machine. Since the old machine is kept and

not disposed of, Exhibit 22-4, item c, shows after-tax cash flow from current disposal of old machine of $0 in year 0.

d. Lost tax shield from current disposal of machine. As the old machine is not sold,no tax shield adjustments are required.

e. Recurring after-tax cash operating flows.

Recurring cash operating flows (costs) for the old machine $(250,000)

Deduct: Income tax savings at 30% of $250,000 75,000

Recurring after-tax cash operating flows $(175,000)

After-tax cash operating flows of $(175,000) in years 1 to 4 appear as relevant

cash outflows in Exhibit 22-4, item e. Our example assumes that PotatoSupreme’s income tax rate is 30% each year. When future tax rates are uncer-tain, analysts must predict the tax rate applicable for each year of a project.

f. Cash flow from proceeds of disposition of old machine. Other assets remain in this asset class.

Proceeds of disposition at end of year 4 $6,000

The cash flow of $6,000 from the proceeds of disposition of the old machineappears as a cash inflow in year 4 of Exhibit 22-4, item f.

g. Lost tax shield. The proceeds of disposition of $6,000 would reduce the CCA pool by $6,000, and thus reduce the future cash savings from capital cost allowance deductions by $1,145.854 CHAPTER 22

Total-project approach. Approach to decision making that incorporatesall relevant revenues and relevantcosts under each alternative.In capital budgeting decisions,calculates the present value of allfuture cash inflows and outflowsunder each alternative separately.

Net addition. The differencebetween the purchase price of thenew equipment and the proceedsof disposition of the old equipment.When the purchase price exceeds the proceeds of disposition the half-year rule applies when calculating

the lost tax shield; otherwise, thehalf-year rule applies.



($6,000 0.30)

$1,800 2 3 0.955 $1,146

Exhibit 22-4 presents all after-tax cash flows that would arise if Potato Supreme continued to use the old packaging machine. Each cashflow is multiplied by its corresponding present value discount factor togive its present value. The total present value is $(551,435).

◆ Step 2: Calculate the present value of total cash flows of immediately replacing the old packaging machine.

a. Initial machine investment. The original cost of the new packaging machine is$200,000. This amount appears as a cash outflow in year 0 in Exhibit 22-5,item a (p. 856).

b. Tax shield. The original cost of $200,000 will generate a cash savings fromcapital cost allowance of $38,160. This amount is determined by using the taxshield formula.

($200,000 0.30)

$60,000

2

3

2.1

2.2 $40,000 0.955 $38,200

Recall that the tax shield formula calculates the present value of the cash flows.

c. Cash flow from immediate proceeds of disposition.

Immediate proceeds of disposition $26,000

Review what is included in the present value analysis. It is the immediatecash inflow from the proceeds of disposition of the asset. The book value of the old machine and the loss on disposal do not themselves affect cash flow. The book value, however, enters into the calculation of the loss on disposal of the asset, which in turn affects the accounting net income.

2 0.10

2(1 0.10)0.20

(0.20 0.10)

2 0.102(1 0.10)

0.20

(0.20 0.10)


A CLOSER LOOK

Present Value

Total Discount Present Factors Value at 10%

End of Year: 0 1 2 3 4

Explanations for the after-tax cash flowamounts are given on pp. 854−855.

a. Initial machine investment $ 0 1.000 $0

c. After-tax cash flow from immediateproceeds of disposition 0 1.000 0

e. Recurring after-taxcash operating flows (554,750) 3.170 $(175,000) $(175,000) $(175,000) $(175,000)

f. Cash flow from proceedsof disposition in four years’ time 4,098 0.683 6,000

g. Lost tax shield from thedisposal in four years’ time (783) 0.683 ($1,146)

Total present value of all cashflows if Potato Supremereplaces the old machine infour years’ time $(551,435)

Note: Parentheses denote relevant cash outflows throughout all exhibits in this chapter.

EXHIBIT 22-4Total-Project Approach for Potato Supreme: After-Tax Analysis of Replacing Old Machine in Four years’ Time

Sketch of Relevant After-Tax Cash Flows



d. Lost tax shield from immediate disposal of old machine. The current disposal of $26,000 would reduce the cash savings from future capital cost allowance by $4,966.

($26,000 0.30)

$7,800

2

3 0.955

$4,966

In this case, the half-year rule applies to the calculation of the tax shield for-mula because the net addition is a positive number ($200,000–$26,000).

e. Recurring after-tax cash operating flows.

Recurring cash operating flows (costs) for the new machine $(150,000)

Deduct: Income tax savings (30% $150,000) 45,000

Recurring after-tax cash operating flows $(105,000)

The after-tax cash operating flows of $(105,000) in years 1 to 4 appear asrelevant cash outflows in Exhibit 22-5, item e.

f. Cash flow from proceeds of disposition of new machine. Other assets remain in this asset class.

Proceeds from disposition of new machine $20,000

g. Lost tax shield from disposition of new machine in four years’ time. Assume no futurereplacement for the new machine. Therefore, the net addition ($0–$20,000) willbe negative and the half-year rule will not apply. The proceeds of disposition

2 0.102(1 0.10)

0.20

0.20 0.10

856 CHAPTER 22

EXHIBIT 22-5Total-Project Approach for Potato Supreme: After-Tax Analysis of Immediately Purchasing the New Machine

Present Value



Explanations for the after-taxcash flow amountsare given on pp. 855 and 856.

a. Initial machine investment $(200,000) 1.000 $(200,000)

b. Tax shield 38,200 1.000 $ 38,200

$(161,800)

c. Cash flow from immediateproceeds of dispositionof old machine 26,000 1.000 $ 26,000

d. Lost tax shield from immediatedisposal of old machine $ (4,966) 1.000 $ (4,966)

Net investment $(140,766)

e. Recurring after-taxcash operating flows (332,850) 3.170 $(105,000) $(105,000) $(105,000) $(105,000)

f. Cash flow from proceeds ofdisposition of the new machinein four years’ time disposal of new machine 13,660 0.683 $20,000

g. Lost tax shield from disposal of thenew machine in four years’ time (2,732) 0.683 (4.000)

Total present value of all cash flowsif Potato Supreme immediately replaces the old machine $(462,688)




of $20,000 would reduce the future cash savings from CCA at the maximumrate of 20% by $2,732.

($20,000 0.30)

$6,000

2

3 $4,000

Exhibit 22-5 summarizes the relevant after-tax cash flows that would occur if Potato Supreme replaced its old machine immediately. Present values are derived by multiplying cash flows by the corresponding present value discount factors. Thetotal present value of cash flows equals $(462,688). Recall from Exhibit 22-4 that thepresent value of after-tax cash flows of replacing the old machine in four years’ timeis $(551,435). The decision to replace the old machine with the new machine imme-

diately has a positive net present value of $88,747 ($551,435 $462,688) and istherefore preferred.

Differential Approach

Unlike the two-step total-project approach, the differential approach is a one-stepmethod that includes only those cash inflows and outflows that differ between thetwo alternatives. The differential approach compares the cash outflows arising fromreplacing the old machine with the savings in future cash outflows resulting fromusing the new machine rather than the old machine. We will now examine the differ-ences in cash flows between the keep and replace alternatives in the Potato Supremeexample using the categories of cash flows that we described earlier.

0.20(0.20 0.10)


A CLOSER LOOK

Present Value



Explanations for the after-tax inflowamounts are given on pp. 856 and 857.

a. Initial machine investment $(200,000) 1.000 $(200,000)

c. Cash flow from immediate proceedsof disposition of old machine 26,000 1.000 26,000

Net initial investment (174,000) (174,000)

b. net of d. Tax shield (Exhibit 22-5) 33,234 1.000 33,234

(140,766)

e. Recurring after-tax cash operating flows221,900 3.170 $70,000 $70,000 $70,000 $70,000

f. Cash flow from proceeds of dispositionof old machine in four years’ time (4,098) 0.683 $ (6,000)

g. Lost tax shield from disposal

of old machine in four years’ time 783 0.683 $ 1,146(3,315)

f. Cash flow from proceeds of dispositionof new machine in four years’ time ($551,435–$462,688) $88,747 13,660 0.683 $20,000

g. Lost tax shield from disposalof new machine in four years’ time (2,732) 0.683 $ (4,000)

10,928

Net present value if old machine isreplaced immediately $ 88,747

EXHIBIT 22-6Differential Approach for Potato Supreme: After-Tax Analysis of Replacing Old Machine




a. Initial machine investment of $200,000 for the new machine (see Exhibit 22-5)appears as a cash outflow in year 0 in Exhibit 22-6, item a.

c. Cash flow from immediate proceeds of disposition of old machine of $26,000(see Exhibit 22-5) appears as a cash inflow in year 0 in Exhibit 22-6, item c. The initial machine investment, $200,000, minus the cash flow fromcurrent disposal of the old machine, $26,000, is the net initial investment of $174,000, shown as a cash outflow in year 0 in Exhibit 22-6.

b. net of d. Tax shield. The net initial investment of $174,000 would increase theCCA pool by this amount and thus would generate cash savings from

CCA from now to infinity. The cash savings would be $33,199, a figuredetermined by using the tax shield formula:

($174,000 0.30)

$52,200

2

3 0.955

$33,234

e. Recurring after-tax cash operating flows. Replacing the old machine resultsin lower after-tax cash operating costs, as follows:

Recurring after-tax cash operating costsif old machine kept (Exhibit 22-4, item e) $175,000

Deduct: Recurring after-tax cash operating costsif machine replaced (Exhibit 22-5, item e) 105,000

Savings in recurring after-tax cash operating costsif machine replaced $ 70,000

Exhibit 22-6, item e, shows this $70,000 increase in recurring after-taxcash operating flows in years 1–4.

f. net of g. Cash flow from proceeds of disposition of each machine in four years’ time, net of the lost tax shield of each respective disposal. The immediate disposition of the old machine results in no disposition of this machine in four years’time. This opportunity cost for the old machine based on Exhibit 22-4 is$3,315 ($4,098 to $793) for the old machine. The opportunity cost forthe new machine based on Exhibit 22-5 is $10,928 ($13,550–$2,732).

In Exhibit 22-5, the terminal disposal of the new machine for $20,000 will result ina lost tax shield of $2,732, the net of which is $10,928.

Both the total-project approach (Exhibits 22-4 and 22-5) and the differential approach(Exhibit 22-6) result in a net present value of $88,747 in favour of immediately replacing the old packaging machine with the new one. When comparing alternatives, these twoapproaches will always give the same net present value.

(2 0.10)2(1 0.10)

0.20

(0.20 0.10)

858 CHAPTER 22

Capital Budgeting and Inflation

Inflation can be defined as the decline in the general purchasing power of the mon-etary unit (for example, the dollar in Canada or the yen in Japan). An inflation rate of 10% in one year means that what you could buy with $100 (say) at the start of the

year will cost you $110 [$100 (10% $100)] at the end of the year. Prices increaseas more money chases fewer goods. Some countries—for example, Brazil, Israel, Mexico, and Russia—have experienced annual inflation rates of 15% to more than100%. Even an annual inflation rate of 5% over, say, a five-year period can result insizable declines in the general purchasing power of the monetary unit over that time.

Why is it important to account for inflation in capital budgeting? Becausedeclines in the general purchasing power of the monetary unit (say, dollars) will inflatefuture cash flows above what they would have been had there been no inflation. These inflated cash flows will cause the project to look better than it is, unless theanalyst recognizes that the inflated cash flows are measured in dollars that have lesser value than the dollars that were initially invested. We now examine how inflation canbe explicitly recognized in capital budgeting analysis.

O B J E C T I V E 5

Distinguish between the realrate of return and thenominal rate of return

Inflation. The decline in the generalpurchasing power of the monetaryunit.



Real and Nominal Rates of Return

When analyzing inflation, distinguish between the real rate of return and the nomi-nal rate of return:

◆ Real rate of return is the rate of return required to cover only investment risk.

◆ Nominal rate of return is the rate of return required to cover investment risk and the anticipated decline, due to inflation, in the general purchasing powerof the cash that the investment generates. The rates of return (or interest)earned on the financial markets are nominal rates, because they compensate

investors for both risk and inflation. We next describe the relationship between real and nominal rates of return. Assumethat the real rate of return for investments in high-risk cellular data transmissionequipment at Network Communications is 20% and that the expected inflation rateis 10%. The nominal rate of return1 is:

Nominal rate (1 Real rate)(1 Inflation rate) 1

(1 0.20)(1 0.10) 1

[(1.20)(1.10)] 1 1.32 1 0.32

The nominal rate of return is also related to the real rate of return and the inflationrate as follows:

Real rate of return 0.20

Inflation rate 0.10

Combination (0.20 0.10) 0.02

Nominal rate of return 0.32

Note that the nominal rate is slightly higher than the real rate (0.20) plus theinflation rate (0.10). Why? Because the nominal rate recognizes that inflation alsodecreases the purchasing power of the real rate of return earned during the year.

Net Present Value Method and Inflation

The watchwords when incorporating inflation into the net present value (NPV) methodis internal consistency. There are two internally consistent approaches:

◆

Nominal approach. Predict cash inflows and outflows in nominal monetary unitsand use a nominal rate as the required rate of return.

◆ Real approach. Predict cash inflows and outflows in real monetary units and usea real rate as the required rate of return.

Consider an investment that is expected to generate sales of 100 units and anet cash inflow of $1,000 ($10 per unit) each year for two years absent inflation. If infla-tion of 10% is expected each year, net cash inflows from the sale of each unit would be$11 ($10 1.10) in year 1 and $12.10 [$11 1.10 or $10 (1.10)2] in year 2 resultingin net cash inflows of $1,100 in year 1 and $1,210 in year 2. The net cash inflows of $1,100 and $1,210 are nominal cash inflows because they include the impact of infla-tion. These are the cash flows recorded by the accounting system. The cash inflows of $1,000each year are real cash flows because they exclude inflationary effects. Note that the real

cash flows equal the nominal cash flows discounted for inflation, $1,000

$1,100

1.10 $1,210 (1.10)2. Many managers find the nominal approach easier to under-stand and use, because they observe nominal cash flows in their accounting systems andthe nominal rates of return on financial markets.

Let’s revisit Network Communications, which is deciding whether to invest inequipment to make and sell a cellular data transmission product. The equipment would cost $750,000 immediately. It is expected to have a four-year useful life with azero terminal disposal price. An annual inflation rate of 10% is expected over this


A CLOSER LOOK

Real rate of return. The rate ofreturn required to cover onlyinvestment risk.

Nominal rate of return. Rate ofreturn required to cover investment

risk and the anticipated decline due to inflation in the general purchasingpower of the cash that theinvestment generates.

O B J E C T I V E 6

Describe two internally consistent ways to account for inflation in capital

budgeting

1 The real rate of return can be expressed in terms of the nominal rate of return as follows:

Real rate 1 − 1 = 0.20(1 0.32)

(1 + 0.10)

(1 Nominal rate)

(1 Inflation rate)



four-year period. Network Communications requires an after-tax real rate of returnof 20% from this project or an after-tax nominal rate of return of 32%.

The following table presents the predicted amounts of real (assuming no infla-tion) and nominal (after considering cumulative inflation) net cash inflows from theequipment over the next four years (excluding the $750,000 investment in the equip-ment and before any income tax payments):

Before-Tax Cumulative Before-Tax Cash Inflows in Inflation Rate Cash Inflows in

Real Dollars Factor * Nominal Dollars

Year (1) (2) (3)

(1)

(2)

1 $500,000 (1.10)1 1.1000 $550,000

2 600,000 (1.10)2 1.2100 726,000

3 600,000 (1.10)3 1.3310 798,600

4 300,000 (1.10)4 1.4641 439,230

*1.10 1.00 0.10 inflation rate.

The income tax rate is 40%. For tax purposes, the equipment will be amortizedusing a capital cost allowance rate of 30%, declining balance method.

Because of inflation, the cash

inflows for future periods will be

measured in dollars that have less value

than the dollars invested in the project

in year 0. Failure to take inflation into

account will overstate the financial

return of the project.

Present Sketch of Relevant After-Tax Cash Flows Value

Total Discount Present Factors Value at 32%†


1. Initial equipment investment:

Investment: Year Outflows

0 $(750,000)

2. Cash savings from tax shield3. Recurring after-tax cash operating flows:

Recurring NominalRecurring After-Tax Nominal Income Cash

Cash Tax Operating Operating Outflows Inflows

Year Inflows (3) (4)(1) (2) 0.40 (2) (2) (3)

1 $550,000 $220,000 $330,000

2 726,000 290,400 435,600

3 798,600 319,440 479,1604 439,230 175,692 263,538

Net present value

*The nominal discount rate of 32% is made up of the real rate of interest of 20% and the inflation rate of 10%: [(1 0.20)(1 0.10)] 1 0.32.†Present value discount factors are shown to six decimal digits to emphasize that the approaches to inflation in Exhibits 22-7 and 22-8 areequivalent. The formula on Table 2 of Appendix A is used to compute the present value discount factor.

‡$(750,000 0.40)

$300,000 0.484 0.879

$127,631.

2 0.322(1 0.32)

0.300.30 0.32

$ (750,000) 1,000000 $(750,000)

$ 127,631

‡

1,000000 $ 127,631$(622,369)

250,000 0.757576 $330,000

250,000 0.573921 $435,600

208,333 0.434789 $479,16086,805 0.329385 $263,538

795,138

$ 172,769

EXHIBIT 22-7Nominal Approach to Inflation for Network Communications: Predict Cash Inflows and Outflows in Nominal Dollars

and Use a Nominal Discount Rate*



Exhibit 22-7 presents the capital budgeting approach for predicting cash flows innominal dollars and using a nominal discount rate.2 The calculations in Exhibit 22-7exactly follow the calculations used in the Potato Supreme example for initial machineinvestment, tax shields, and recurring after-tax cash operating flows.

Exhibit 22-8 presents the approach of predicting cash flows in real terms andusing a real discount rate. The calculations for item 3, recurring after-tax cash operat-ing flows, are basically the same as before except that the cash inflows are measured inreal terms and discounted at real rates.

Both approaches show that the project has a net present value of $172,769 and

should therefore be accepted. Why do the two approaches give the same answer?Because, for example, in going from the real approach to the nominal approach, thecash flows are multiplied by and the discount rates are divided by the same cumulativeinflation factor.3


A CLOSER LOOK

Under the nominal approach, first

express all amounts in terms of

future-year dollars (using cumulative

inflation rate factors), then discount the

resulting amounts to their present value

using nominal discount-rate factors .

2 The present value discount factors in the example are calculated using six decimal digits to eliminatedoubt about the equivalence of the two approaches. In practice, the present value discount factors (tothree decimal digits) can be obtained using Table 2 (present value of $1) of Appendix A at the end of the text. The Problem for Self-Study at the end of this chapter uses Table 2.

3For example, recurring after-tax real cash operating flow in year 2 of $360,000 in Exhibit 22-8 ismultiplied by (1.10)2 to give $435,600 in after-tax nominal cash operating flows in year 2 inExhibit 22-7. The real discount rate of 0.694444 in year 2 in Exhibit 22-8 is divided by (1.10)2 togive the nominal discount rate of 0.573921 in year 2 in Exhibit 22-7.

Present Sketch of Relevant After- Value Tax Cash Flows

Total Discount Present Factors

Value at 20%*

End of Year:

1. Initial equipment investment:

Investment Year Outflows

0 $(750,000)

2. Cash savings from tax shield†

3. Recurring after-tax cash operating flows:

Recurring Recurring Real After-Real Cash Income Tax Cash

Operating Tax Operating Year Inflows Outflows Inflows(1) (2) (3) (4)

0.40 (2) (2) (3)

1 $500,000 $200,000 $300,000

2 600,000 240,000 360,000

3 600,000 240,000 360,000

4 300,000 120,000 180,000

Net present value

*Present value factors are shown to six decimal digits and the present value calculations rounded to emphasize that the approaches to inflation inExhibits 22-7 and 22-8 are equivalent. The formula on Table 2 of Appendix A is used to compute the present value discount factor.

†

The computation of these inflation factors is explained in footnote 3 below.‡ The tax shield formula has used the nominal rate of 32% for demonstration purposes. It is common for companies to use a nominal rate, eventhough capital cost allowance amounts are not inflated.

0 1 2 3 4

$ (750,000) 1.000000 $(750,000)127,631‡ 1.000000 127,631

$(622,369)

250,000 0.833333 $300,000

250,000 0.694444 $360,000

208,333 0.578704 $360,000

86,805 0.482253 $180,000

795,138

$ 172,769

EXHIBIT 22-8Real Approach to Inflation for Network Communications: Predict Cash Inflows and Outflows in Real Dollarsand Use a Real Discount Rate



The most frequently encountered error when accounting for inflation in capi-tal budgeting is stating cash inflows and outflows in real monetary units and using anominal discount rate. This error understates the discounted present value of cashflows that occur in the future and therefore creates a bias against the acceptance of many worthwhile capital investment projects.

862 CHAPTER 22

Project Risk And Required Rate Of Return

The required rate of return (RRR), which we discussed in Chapter 21, is a critical variable

in discounted cash flow analysis. It is the rate of return that the organization forgoes by investing in a particular project rather than in an alternative project of comparable risk. Risk here refers to the business risk of the project, independent of the specific manner in which the project is financed—whether with debt or with equity. Here is a safe general-ization: The higher the risk, the higher the required rate of return and the faster man-agement would want to recover the net initial investment. Why? Because higher risk means a greater chance that the project may lose money. Management would only be willing to take this added risk if it was compensated with a higher expected return.

The RRR used in discounted cash flow analysis should be internally consistent with the approach applied to predict cash inflows and outflows. The options include various combinations of (1) the real rate and the nominal rate and (2) the pretax andthe after-tax rate. The differences among these rates can be sizable, given estimatesof inflation that may exceed 10% and corporate tax rates of 30% or more.

Organizations typically use at least one of the following approaches in dealing with the risk factor of projects (see Global Surveys of Company Practice on p. 863):

1. Varying the required payback time. Companies such as Nissan that use pay-back as a project selection criterion vary the required payback to reflect differ-ences in project risk. The higher the risk, the shorter the required payback time. When faced with higher risk, companies also evaluate how to minimizetheir downside risk if the project is prematurely abandoned before the full cashinflows can be realized. A reason for abandoning a project prematurely arises(as it did for Ontario Power Generation) when government policies regardingenvironmental protection change and current projects in operation, such as acoal-fired electricity-generating plant, cannot be refurbished (see the Conceptsin Action feature on p. 867).4

2. Adjusting the required rate of return. Companies such as DuPont and ShellOil use a higher required rate of return when the risk is higher. Estimating aprecise risk factor for each project is difficult. Some organizations simplify thetask by having three or four general-risk categories (for example, very high,high, average, and low). Each project under consideration is assigned to a spe-cific category. Management uses a predetermined discount rate, assigned toeach category, as the required rate of return for projects in that category.

3. Adjusting the estimated future cash inflows. Some companies, such as Dow Chemical, reduce the estimated future cash inflows of riskier projects. Forexample, they may systematically reduce the predicted cash inflows of very-high-risk projects by 30%, high-risk projects by 20%, and average-risk projectsby 10%, and make no change to the projected cash inflows of low-risk projects. This approach is called the certainty equivalent approach. Since the cash flows forhigher-risk projects have already been adjusted downward for their increasedriskiness, the RRR used to evaluate those projects is the same as the RRR forlow-risk projects. Note how this approach contrasts with adjusting the requiredrate of return. In that approach, the cash flows are not adjusted for risk, but theRRR is. In the certainty equivalent approach, the cash flows are adjusted forrisk, but the RRR is not. Both adjusting the cash flows for risk and then usingrisk-adjusted RRRs would double-count the risk adjustment.

O B J E C T I V E 7

Describe alternativeapproaches used torecognize the degree of risk in capital budgeting projects

4See J. Grinyer and N. Daing, “The Use of Abandonment Values in Capital Budgeting––A Research Note,” Management Accounting Research 4 (1993).

Ontario Power Generation—Operationswww.opg.com/ops/H_hydro_overview.asp



4. Sensitivity (what-if) analysis. Companies such as Consumers Energy Company use this approach to examine the consequences of changing key assumptionsunderlying a capital budgeting project (see the Concepts in Action box on p. 865).

5. Estimating the probability distribution of future cash inflows and outflows for each project. Companies such as Niagara Mohawk use the approach to uncertainty that was discussed in the appendix to Chapter 3. The approach gives due weight to allpossible cash flow outcomes to arrive at an expected cash flow and then discounts thisamount at the risk-adjusted required rate of return for the investment. Estimatingthese probability distributions is difficult, but a practical guideline is to limit the num-

ber of outcomes under consideration to a small, manageable set. Consider anotherbenefit of estimating the probability distribution of future cash inflows and outflows.Suppose a project has a 60% likelihood of very high cash inflows and a 40% likeli-hood of minimal cash inflows in its early years. This 40% probability may prompt managers to establish lines of credit with a bank. If the low outcome occurs, theselines of credit would enable the company to avoid a short-run cash flow crisis.


A CLOSER LOOK

Applicability To Not-for-profit Organizations

Discounted cash flow analysis applies to both profit-seeking and not-for-profit organizations. Almost all organizations must decide which investments in long-termassets will accomplish various tasks at the least cost.

CMS Energywww.cmsenergy.com/AboutCMS

Risk Adjustment Methods in Capital BudgetingHow do companies around the globe adjust for risk when evaluating capital investments?The percentages in the following table indicate how frequently particular risk adjustmentmethods are used in capital budgeting in four countries. The reported percentagesexceed 100% because some companies use more than one risk adjustment method.Dashes indicate information was not disclosed in survey.

United UnitedCanada* States† Australia‡ Kingdom§ Taiwan|| Poland #

Sensitivity analysis 59% 29% 57% 63% — 10%

Increase the required rate of return 31% 18% — 42% 61% 13%

Shorten payback period 24% 17% — 34% 72% 25%

Estimate probability distributionof future cash flows 18% 12% 11% 15% — 13%

Compare optimistic andpessimistic forecasts — — 63% — — —

Make subjective,nonquantitative assessment 29% 54% 37% 22% 69% 4%

Make no adjustments 10% 37% — — — —

The surveys indicate that the specific methods managers use vary among countries.A common feature, however, is that managers appear to favour simpler methods (forexample, sensitivity analysis, shortening the payback period, increasing the required rateof return, and subjective, nonquantitative assessments) rather than more sophisticated techniques (for example, estimating the probability distribution of future cash flows).

Adapted from: *Jog, V., and A. Srivastava, “Corporate Financial Decision Making in Canada,” Canadian Journal

of Administrative Sciences (1994); †Sullivan, C., and K. Smith, “Capital Investment Justification for U.S. FactoryAutomation Projects,” Journal of the Midwest Finance Association ; ‡Freeman, M., and G. Hobbes, “CapitalBudgeting: Theory versus Practice,” Australian Accountant ; §Ho, S., and R. Pike, “Risk Analysis in CapitalBudgeting Contexts: Simple or Sophisticated?” Accounting and Business Research ; ||Ho, S., and L. Yang,“Managerial Risk Taking and Handling in Corporate Investment: An Exploratory Study in Taiwan,” Proceedings

of the Second International Conference on Asian-Pacific Financial Markets ; # Zarzecki, D., and T. Wisniewski,

“Investment Appraisal Practice in Poland” (Working Paper, Szcecin University, Szcecin, Poland).

G L O B A L S U R V E Y S O F C O M P A N Y P R A C T I C E



Studies of the capital budgeting practices of government agencies at variouslevels (federal, provincial, and local) and in several countries report that, as in theprofit-oriented sector, the following prevails:

1. Urgency is an important factor when allocating funds. For example, capitalbudgeting for roads is often motivated by physical deficiencies in an existinghighway rather than a systematic analysis of alternative road constructionprojects.

2. Project estimates are sometimes systematically biased. For example, studies report

overestimates of the benefits, underestimates of the costs, and underestimates of the time it takes to construct dams and other irrigation infrastructures.

3. There is a tendency to cut capital-budget projects first when there is a strongpush to balance a budget or reduce a deficit. Consider the effect of efforts tocontain health-care costs in Canada. As a result of these changes and theincreased emphasis on controlling hospital charges through competition andregulation, hospitals are increasingly using analytical capital budgeting meth-ods (such as discounted cash flow methods) and are also more carefully audit-ing the benefits of capital expenditures.

864 CHAPTER 22

Implementing The Net Present Value Decision Rule

Executives in both profit-seeking and not-for-profit organizations must frequently work within an overall capital budget limit. This section discusses problems in usingthe net present value method when there is a restriction on the total funds availablefor capital spending.

The excess present value index (sometimes called the profitability index) is thetotal present value of future net cash inflows of a project divided by the total present value of the net initial investment. The following table illustrates this index for twosoftware graphics packages—Superdraw and Masterdraw—that Business Systems isevaluating:

Present Value Net Excessat 10% Initial Present Value Net RRR Investment Index Present Value

Project (1) (2) (3) (1) (2) (4) (1) (2)

Superdraw $1,400,000 $1,000,000 140% $400,000

Masterdraw 3,900,000 3,000,000 130% 900,000

The excess present value index or profitability index measures the cash flow returnper dollar invested. The index is viewed as particularly helpful in choosing betweenprojects when investment funds are limited. Why? Because profitability indexes canidentify the projects that will generate the most money from the limited capitalavailable.

Suppose that the developers of each package require that Business Systemsmarket only one software graphics package, so accepting one software package auto-matically means rejecting the other––that is, the packages are mutually exclusive. Which package should Business Systems choose?

Using the profitability index, Superdraw will be preferred over Masterdraw,because it has a profitability index of 140%, which is higher than the 130% for Masterdraw. But the profitability index analysis assumes that all other things, such asrisk and alternative use of funds, are equal. For example, it assumes that choosingbetween Superdraw and Masterdraw has no effect on the other projects that Business Systems plans to implement. If “all other things” are not “equal,” which isoften the case, the profitability index may not result in the optimal choice of invest-ment projects.

Continuing the Business Systems example, assume that Business Systems has atotal capital budget limit of $5,000,000 for the coming year. It is considering invest-ing in Superdraw or Masterdraw and in any one or more of eight other projects

O B J E C T I V E 8

Explain the excess present value index and its usefulnessin capital budgeting

Excess present value index.Capital budgeting measure in which the total present value of future netcash inflows of a project is divided by the total present value of the netinitial investment.



The NPV method always indicates the project (or set of projects) that maximizes theNPV of future cash flows. However, surveys of practice report widespread use of theinternal rate-of-return (IRR) method. Why? Probably because managers find thismethod easier to understand and because, in most instances, their decisions would beunaffected by using one method or the other. In some cases, however, the two methods will not indicate the same decision.

Where mutually exclusive projects have unequal lives or unequal investments,

the IRR method can rank projects differently from the NPV method. ConsiderExhibit 22-10.5 The ranking by the IRR method favours project X, while the rankingby the NPV method favours project Z. The projects ranked in Exhibit 22-10 differin both life (5, 10, and 15 years) and net initial investment ($286,400, $419,200, and$509,200).

866 CHAPTER 22

Implementing The Internal Rate-Of-Return Decision Rule

O B J E C T I V E 9

Explain why the internalrate-of-return and the net present value decision rulesmay rank projects differently

5Exhibit 22-10 concentrates on differences in project lives. Similar conflicting results can occur when the terminal dates are the same but the sizes of the net initial investments differ.

IRR Method NPV Method

Annual PV of Annual Net Cash Flow from Cash Flow from Initial Operations, Operations,

Project Life Investment Net of Income Taxes IRR Ranking Net of Income Taxes NPV Ranking

X 5 $286,400 $100,000 22% 1 $379,100 $ 92,700 3

Y 10 419,200 100,000 20 2 614,500 195,300 2

Z 15 509,200 100,000 18 3 760,600 251,400 1

EXHIBIT 22-10Ranking of Projects Using Internal Rate of Return and Net Present Value

(coded B, C, . . . , H, I). Exhibit 22-9 on page 865 presents two alternative combina-tions of these projects. Note that the project portfolio in alternative 2 is superior tothat in alternative 1, despite the greater cash flow return per dollar invested inSuperdraw than in Masterdraw. Why? Because the $2,000,000 incremental invest-ment in Masterdraw increases net present value (NPV) by $500,000. The $2,000,000 would otherwise be invested in projects E and B, which have a lower combined NPV of $256,000:

Net Initial Increase in Net Present Value Investment Present Value

Masterdraw $3,900,000 $3,000,000

Superdraw 1,400,000 1,000,000

Increment $2,500,000 $2,000,000 $500,000

Project E $ 912,000 $ 800,000

Project B 1,344,000 1,200,000

Total $2,256,000 $2,000,000 $256,000

Note that other than Superdraw, alternative 2 includes projects with the highest excess present value indexes and excludes those with the lowest excess present valueindexes. The excess present value index is a useful guide for identifying and choosingprojects that will offer the best return on limited capital and that will thereby maxi-mize net present value. But managers cannot base decisions involving mutually

exclusive investments of different sizes solely on the excess present value index. Thenet present value method is the best general guide.



Managers using the IRR method implicitly assume that the reinvestment rate isequal to the indicated rate of return for the shortest-lived project. Managers using theNPV method implicitly assume that the funds obtainable from competing projects canbe reinvested at the company’s required rate of return. The NPV method is generally regarded as conceptually superior. Students should refer to corporate finance texts formore details on these issues, and on the problems of ranking projects with unequallives or unequal investments.

In response to concerns about the environment, governments have passed manylaws to restrict companies’ impacts on the environment. Many companies have viewed these laws as imposing costs on them, but attitudes are changing. Companies areincreasingly shifting their focus away from pollution control (dealing with the control ofenvironmentally harmful substances) to pollution prevention (minimizing the creation ofpollution in the first place, through increased efficiency in the use of materials, energy,water, and other resources). Intelligent use of capital budgeting methods is a key part

of this effort.Suppose a company invests in new manufacturing equipment that

allows it to use a less costly and nontoxic direct material. Annual costsavings directly associated with the use of the new equipment includesavings in direct material costs and toxic waste disposal. If the capitalbudgeting analysis ended at this point, however, the investment mightshow a negative NPV, and the company would, on purely financialgrounds, reject the project.

But companies such as DuPont consider other financial benefits.These benefits include cost savings in pol lution control activities such asmonitoring and testing, permit requirements, and legal compliance report-ing. These costs are “hidden” in that they are included in general overhead

accounts but typically not identified with specific manufacturing processes.There can also be “hidden” impacts on a company’s revenues. For example, the periodic training of employees in pollution control activi ties adds tocosts, and, when there is no idle time, results in lost revenues as a result ofhaving to shut down the plant for a few hours each time a training sessionis conducted.

Another form of cost savings is the reduction or elimination of variousfines or penalties that a company might experience because of noncompli-ance or accidents. Estimating these costs is more difficult and is generallybased on statistical analysis of historical data for the particular company orindustry, probability calculations, and professional judgment. Many companies believe anuncertain monetary estimate is probably better than ignoring the potential environmentalliability altogether.

Finally, there are more-intangible financial benefits, such as higher revenuesfrom being a more environmentally responsible company. Home Depot buys its lumberproducts only from a list of “preferred vendors” that it knows to conduct environmentallyresponsible practices.

Source: D. Jacque Grinnell and Herbert G. Hunt, “Capital Budgeting for Pollution Prevention,” Journal

of Cost Management ; Environmental Protection Agency, “Valuing Potential Environmental Liabilitiesfor Managerial Decision Making”; conversations with consulting firm SmithObrien and companymanagements.

C O N C E P T S I N A C T I O N

Capital Budgeting for Pollution Prevention


A CLOSER LOOK



Companies may claim up to the percentages shown of the UCC in any year for thespecified class of tangible assets (see the table below). The legislation regarding CCA only allows this annual deduction if the asset can be classified under the act; otherwiseno deduction is permitted. In establishing the initial value of the asset, if the company has or is entitled to receive financial assistance to acquire the asset, then the dollar valueof this assistance may reduce the asset’s initial value. In addition, if during the useful lifeof the asset its value is reappraised downwards, then the UCC must also decrease.

Class Maximum CCA Tangible Assets in Pool

1 4% Buildings or other structures, including component partsacquired after 1987

3 5% Buildings or other structures, including component partsacquired before 1988

8 20% Miscellaneous tangible capital property and machinery orequipment not included in another class

9 25% Electrical generating equipment, radar and radio equipmentacquired before 1976

10 30% Automotive equipment and general-purpose electronic dataprocessing equipment with its systems software

12 100% Tools or utensils costing less than $200, videotape, certifiedfeature films, computer software

29 Property used in manufacturing or processing acquired before1988 (2 years straight-line)

39 Property used in manufacturing or processing acquired after 1987(1988–40%; 1989–35%; 1990–30%; after 1990–25%)

Canada Revenue Agencywww.cra-arc.gc.ca/E/pub/

tp/it285r2/it285r2-e.html

CCA Classeswww.cra-arc.gc.ca/tax/business/topics/solepartner/reporting/capital/classes-e.html

Appendix: CCA Classes And Rates

PROBLEM FOR SELF-STUDY

This is a comprehensive review problem. It illustrates both income tax factors and capital budgeting with inflation.

PROBLEM

Stone Aggregates (SA) operates 92 plants producing a crushed stone that is usedin many construction projects. Transportation is a major cost item. A scale clerk weighs the products and, on a delivery ticket, records details of the product shipped: its weight, its freight charges, and whether or not it is taxed.

SA is considering a proposal to use computerized delivery ticket–writingequipment at each of its 92 plants. One plant has used the equipment as a pilot site for the past 12 months, generating cash operating cost savings (before taxes)of $300,000 by improving productivity and by reducing plant operating costs andexcess shipments to customers. The cost analyst estimates that if the equipment had been in use at all of the company’s plants for the past year, net cost savings would have been $25 million (expressed in today’s dollars).

The cost of the equipment for all 92 plants is $45 million, which wouldbe payable immediately. This equipment has an expected useful life of four

years and a terminal disposal price of $10 million (expressed in today’s dollars). The equipment qualifies for a capital cost allowance rate of 25% decliningbalance. Stone Aggregates expects a 30% income tax rate in each of the next four years.

R EQUIRED

1. Does the proposal for the computerized delivery ticket-writing equipment meet SA’s 16% after-tax required rate-of-return criterion? This rate of returnincludes an 8% inflation component. (The real rate of return is 7.4%; recallthat nominal rate of return [(1 0.074)(1 0.08)] 1 0.16.) This 8%



inflation prediction applies to both the cost savings and the terminal disposalprice of the equipment. Compute the NPV using nominal dollars and a nomi-nal required rate of return.

2. What other factors would you recommend that SA consider when evaluatingthe computerized delivery ticket-writing equipment?

SOLUTION1. Exhibit 22-11 shows the NPV computations. To illustrate an alternative

presentation found in practice, the format of Exhibit 22-11 differs from that of Exhibits 22-4, 22-5, and 22-6 (pp. 855, 856, and 857). The proposal forcomputerized delivery ticket–writing equipment has an NPV of $29,560million, indicating that—on the basis of financial factors—it is an attractiveinvestment.

2. The analysis in Exhibit 22-11 assumes that net cash savings are $25 millioneach year. However, operating and implementation costs in the year of changeover to new computerized equipment are often 200% higher than insubsequent years. Consequently, net cash savings may be lower in the first year.

EXHIBIT 22-11Net Present Value Analysis of Computerized Delivery Ticket-Writing System for Stone Aggregates (in Thousands;n.d. Nominal Dollars)

A B C D E F

1 Total End of End of End of End of

2 Present Value Year 1 Year 2 Year 3 Year 4

3 Recurring After-Tax Cash Operating Flows

4 1. Recurring cash operating savings (real dollars) $ – $25,000 $25,000 $25,000 $25,000

5 2. Cumulative inflation factor (from Table 1, Appendix A for 8%) – 1.080 1.166 1.260 1.360

6 3. Cash operating savings (n.d.): 1 2 $27,000 $29,150 $31,500 $34,000

7 4. Tax payments: 30% 3 8,100 8,745 9,450 10,2008 5. Recurring after-tax cash operating savings (n.d.): 3 4 $18,900 $20,405 $22,050 $23,800

9 6. Present value discount factor (16% nominal) 0.862 0.743 0.641 0.552

10 7. P.V. of recurring after-tax cash operating savings (n.d.): 5 6 $ 58,726 $16,292 $15,161 $14,134 $13,138

11

12 Initial Equipment Investment

13 New equipment $(45,000)

14 Tax shield 7,664*

15 After tax cash flow effect of equipment investment (37,336)

16 Terminal disposal 10,000

17 Lost tax shield (1,829)†

18 After tax cash flow effect of terminal disposal (8,171)

19 Net present value $ 29,560

20

21 *Tax shield ($45,000 0.30) $7,664(2 0.16)

2(1 0.16)

0.25

0.25 0.16

22 †Lost tax shield ($10,000 0.30) $1,8290.25

0.25 0.16

23 (Half-year rule does not apply to disposals.)



The following decision guidelines use a question-and-answer format to summarize the chapter’s mainpoints. Each decision presents a key question. The guideline is the answer to that question.

D E C I S I O N P O I N T S S U M M A R Y▼

T E R M S T O L E A R N▼

DECISIONS

1. How are operating cash flowsaffected by income taxes?

2. What is capital cost allowance(CCA)?

3. Is an accounting gain on the saleof a capital asset relevant to anassessment of the relevant cashflows related to a new capitalproject?

4. What is the essential differencebetween the total-projectapproach and the differentialapproach to capital budgetingdecisions?

5. What is included in the nominalrate of return that is not in the realrate of return?

6. To recognize the impact of inflation,what must be done when using thenominal approach?

7. Why is it important to recognizerisk when evaluating capitalbudgeting projects?

8. What is the excess present valueindex?

9. Under what condition can the

internal rate-of-return (IRR) and the net present value (NPV)methods rank projects differently?

GUIDELINES

Operating cash flows are multiplied by a rate of 1 minus the tax rate to obtain the after-taxoperating cash flows.

CCA is the ITA equivalent of amortization. It is the only legally allowable deduction permittedwhen a corporation calculates the net taxable income on which income taxes will be based.

No. Accounting gains and losses on the sale of capital assets have no cash flow implications.They are relevant in computing accounting income but are not relevant to an assessment of

the cash flows.

The essential difference is that the total-project approach compares the sum of all of thecash flows between two projects while the differential approach examines the differencesin cash flows for each type of cash flow that varies between two projects.

The nominal rate of return includes the anticipated rate of inflation due to changes in thegeneral purchasing power of the cash flows.

In using the nominal approach, the nominal rate of return must be used and applied to cashflows that have been inflated by recognizing the anticipated rates of inflation.

Risk is an important consideration because riskier projects should require a higher rate ofreturn to compensate for the additional risk.

The excess present value index is the total present value of future net cash inflows ofa project divided by the present value of the net initial investment.

Different rankings of projects can arise when mutually exclusive projects have unequal

lives or unequal investments.

This chapter contains definitions of the following important terms:

capital cost allowance (CCA) (p. 849)cumulative eligible capital (CEC) (p. 851)cumulative eligible capital

amount (CECA) (p. 851)differential approach (p. 853)eligible capital property (p. 851)excess present value index (p. 864)half-year rule (p. 849)

inflation (p. 858)marginal income tax rate (p. 848)net addition (p. 854)nominal rate of return (p. 859)real rate of return (p. 859)tax shield formula (p. 849)total-project approach (p. 854)unamortized capital cost (UCC) (p. 849)

A S S I G N M E N T M A T E R I A L▼QUESTIONS

22-1 Describe three types of cash flows affected by income taxes.

22-2 “It doesn’t matter what accounting amortization method is used The total dollar tax bills are

cc ch 22 capital budgeting and a closer look

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