ACCT 2302 Fundamentals of Accounting II Spring 2011 Lecture 21 Professor Jeff Yu

PV factor of IRR = Initial investment required Net annual cash inflow Simple rate of return Annual Incremental NOI Initial investment = Review: Screening decision of Capital Budgeting NPV = PVs of cash inflows - PVs of cash outflows Payback Method : Payback period is the length of time that it takes for a project to recover its initial investment out of the net cash inflows.

Tax effects in Capital Budgeting Simplifying assumptions: (1) Taxable income equals net income in financial reports; (2) the tax rate is a flat percentage of taxable income. According to tax law, most business revenues are taxable and most business expenses (including depreciation) are tax deductible. However, investments, including working capital, are not tax deductible.

Depreciation Tax Shield Depreciation expense by itself is not a cash flow. But since it is tax deductible, it reduces taxable income by the entire amount of the depreciation deduction (shields some revenue from taxation). So after-tax income will be higher with depreciation deduction than without. Like cost savings, tax savings from the depreciation tax shield can be viewed a cash inflow.

Example Assume a company has a 30% tax rate and a depreciable asset with no salvage value, on which the annual straight-line depreciation expense is $90,000. The depreciation expense is tax deductible. Q: verify the annual tax savings above assuming the annual taxable income before depreciation deduction is $190,000.

Tax effects in Capital Budgeting: Summary 1. Investments: No tax effect. Note: examples of investments include costs of new equipment, working capital needed, release of working capital, etc. 2. Tax-deductible cash expenses: (let tax rate=t) After-tax cost = (1-t)×cash expenses 3. Taxable cash receipts: After-tax benefit = (1-t)×cash receipts 4. Depreciation: Not cash flow, but tax deductible Depreciation tax shield = t × depreciation deduction Note: straight-line depreciation with 0 salvage value is assumed in calculating depreciation deduction.

Holland Co. plans to buy an equipment to open a mine that will be depleted and working capital released in 10 years. Its tax rate is 30% and after-tax cost of capital is 12%. Q: Assume all cash receipts are taxable and all expenses are tax deductible, should Holland purchase the equipment? Practice Problem Cost of equipment $ 300,000 Working capital needed $ 75,000 Annual cash receipts $ 250,000 Annual cash expenses $ 170,000 road repair cost in 6 years $ 40,000 Salvage value in 10 years $ 100,000

Solution to the Practice Problem

Vale Co. has the following data about a 5-year investment project: Q: Assume all cash receipts are taxable and all cash expenses are tax deductible, what is the NPV of the project? Practice Problem Initial Investment$890,000 Annual Cash receipts$534,000 Annual Cash expenses$267,000 Salvage value$45,000 Vale’s tax rate is 30%, discount rate is 10%. For tax purpose, the initial investment will be depreciated (straight-line method) over 3 years without any reduction for salvage value.

For Next Class  Final Exam Review  Attempt the assigned homework problems.

Q: (1) Ignoring any tax effect, which project has higher NPV? (2) For tax purpose, the cost of the new machine will be depreciated over 4 years on a straight-line basis with zero reduction for salvage value. What is the annual tax savings from the depreciation tax shield for Project B? (3) If Project A’s annual net cash inflow is $2,000 for the next 5 years and there is no depreciation deduction, what is the after-tax NPV for Project A? Homework Problem Dana Co.’s cost of capital is 10% and tax rate is 30%. It is deciding whether to repair an old machine (Project A) or to buy a new machine to replace it (Project B). Repairing the old machine costs $5,000 now, while buying a new machine costs $20,000 now. The old machine, after being repaired, will have the same useful life of 5 years as the new machine. But using the new machine will save the company $5,000 per year in operating costs during the next 5 years, compared with using the repaired old machine. The salvage value of the new machine at the end of year 5 is $3,000. The salvage value of the old machine is zero before the repair, but after the repair the old machine can be sold for $2,000 at the end of year 5.