CHAPTER TEN Capital Budgeting: Basic Framework J.D. Han

Learning Objectives 1.Explain net present value (NPV), how it is calculated, and why. 2.Discuss why generating project ideas and estimating cash flows are important. 3.Discuss the difference between operating profit, net profit, and cash flows in evaluating new investments. 4.Discuss the internal rate of return (IRR), how it is calculated, and why and how it differs from net present value. 5.Discuss some of the limitations of discounting cash flow criteria.

10.1 Introduction There are numerous complexities that need to be understood when examining a firm’s capital expenditure decisions such as: - Generating project ideas - Estimating cash flows - Evaluating and selecting projects - Implementing and abandoning projects

10.2 Generating Project Ideas Generating good project ideas is critical for success in capital budgeting A firm should pursue only projects in which it can create sustainable advantages Two ways a company can build competitive advantage are: 1. Differentiation 2. Operating more efficiently (low cost producer)

10.3 Estimating Cash Flows Most critical prerequisite for successful capital budgeting Variable forecasts must be made several years into the future for new products or services such as: - Facility expenditures or Initial Investment - Sales and product prices or Sales Revenue - Operating expenditures - Tax and Tax Credit/Shields

Estimating Cash Flows General issues that arise in deriving cash flows include: Relevance of marginal or incremental cash flow Time Horizon Intangibles External Effects Effects of price-level changes: Inflation Financial charges and taxes Assumptions

A Concrete Example of Cash Flows When you make an investment on a project involving a new machine, there will some cash flows: Gross Cost of the machine: Initial Investment After-Tax Operating Revenue Flows over time = Operating Revenues – Operating Expenses over many periods of time – Corporate Income Tax Some Savings from Investment itself - Tax Shields from CCA over lifetime of the machine - Sales revenue or Salvage of the scrapped machine in the future

Cash Flow Definitions Capital cost allowance (CCA) – the depreciation claim for tax purposes: You can deduct this amount your revenues : Tax savings or Shields = $Value of the Capital times CAA rate times Tax Rate(T) Depreciation – the economic deterioration of an asset as a consequence of its productive life Net operating revenue – is revenues from operations minus all operating expenses excluding taxes and CCA deductions

*Cash Flow Calculations: Different yet Equivalent Ways Alternative 1: Net operating revenue Less: CCA Taxable income Less: Taxes payable Net income or profit Add: CCA Net cash flow Alternative 2: Net operating revenue Less: Tax on NOR After-tax NO revenue Add: Tax savings from CCA Net cash flow Alternative 3: NOR Less: Tax on NOR minus CCA Net Cash flow

Assessing Net Present Value Net present value (NPV) – the sum of all cash flows generated by a project with each cash flow discounted back to the present NPV = - initial investment + present value of after-tax net cash flows + PV of tax savings + PV of salvage (-) NPV indicates the projects fall short of providing necessary return (+) NPV indicates the projects return is greater than the necessary return

Tax Shields: CCA Complications Only half of CCA is allowed in the first year{ eg) CCA for the first year is C times d in theory. However, investment might be made at anytime of the year so CCA is C d times 0.5, tax savings are 0.5 C d times tax rate (= 0.5 C d T) CCA is calculated on Declining-Balance. Each year, CCA is claimed at a constant percentage of the remainnig value eg) The second year the remaining value is CCA = C - C d = C (1-d) CCA is C (1-d) times d Tax Savings are C (1-d) times d times T = C d(1-d) T

Numerical Exmaple Tax rate =0.2 or 20% Initial Investment = 10,000 dollars Depreciation rate =0.3 or 30% per annum Tax Savings for 1 st year = $10000 times 0.3 times 0.2 times 1/2 Tax Savings for 2 nd year= $7000 (10000 minus its first year depreciation or 3000) times 0.3 times 0.2 Tax Savings for 3 rd year = $ 4900 ($7000 minus its second year depreciation or 2100) times 0.3 times 0.2 * Underlined is CCA or deprecitaion for each year.

Declining-Balance vs. Straight- Line Book Value as a Function of Time

Present Value of Tax Shields Present value of tax shields from declining-balance CCA is equal to: 0.5 C d T/(1+k) + C (1-d)d T/(1+k) 2 + C(1-d) 2 d T/(1+k) 3 + …….. = Where C = capital cost of the asset; d = rate of capital cost allowance; T = corporate tax rate; k = discount rate

Present Value of Salvage Value If an asset is expected to be sold at the end of n years for S n the salvage value is deducted from the UCC of the asset class at the time of disposition The present value of lost CCA tax shield due to salvage value is equal to:

Net Present Value (NPV)= Grand Formula: 1(10.3) on Page 360 of the textbook (+) NPV accept project (-) NPV reject project

10.4 Evaluating Projects Methods of evaluating projects include: - Net present value (NPV) - Internal rate of return (IRR) - Profitability index

Internal Rate of Return (IRR) Internal rate of return (IRR) – is the rate of discount that when applied to the cash flows of an investment, will yield an NPV of zero

Discounted Cash Flow (DCF) Criteria Strengths of DCF are that they: - Tie control over the disbursement of funds to the condition under which funds have to be procured - Can be related directly to the goal of maximizing shareholder wealth Limitations of DCF are that they: - Ignore the potentially negative impact that investments may have on financial statements - Ignore non- economic aspects that may be important

Abandoning Projects An important contribution to the success of a firm is the periodical reappraisal of projects to determine whether they should be continued or whether it is necessary to abandon certain projects.

Summary 1.The NPV of a project is defined as the present value of all cash flows discounted at the firm’s cost of capital. It measures the economic gain to be derived over and above the costs of financing a project. 2.In evaluating new projects, we are concerned with identifying marginal, after-tax cash flows excluding any financial charges.

Summary 3.Proper identification of cash flows include the choice of an appropriate time horizon, and the incorporation of anticipated price-level changes. The effects on operating profits and net profits stem are viewed from this context. 4.The IRR measures the effective yield of a project, which is then compared to the cost of funding the investment. It relies on the concepts of discounting and explicitly recognizes the time value of money.

Summary 5.IRR differs from net present value in only the way a problem is analysed. Both criteria usually produce the same investment decisions. 6.The purpose of discounted cash flow criteria is to measure economic gain. They may ignore other non-economic objectives that a firm may have as well as short-run effects of new investments on reported financial statements, in particular on reported earnings.