Loading...

PPT – Capital Cost Allowance (CCA) tax depreciation Tax shield PowerPoint presentation | free to download - id: 3b19ef-NWY4M

The Adobe Flash plugin is needed to view this content

Capital Asset Selection and Capital Budgeting

Chapter 13

Assessing the Profitability of Long-Term

Strategic Investments

The investment in capital assets often coincides

with the execution of major strategies such as

development of new product lines or acquisitions

of other companies. Capital investments are also

associated with major management initiatives to

improve competitive position such as raising

product or service quality through acquisition of

new technology. Other capital investments are

made to maintain and support existing operations.

Capital asset acquisition decisions involve

long-term commitments of large amounts of money.

Making the most economically beneficial

investments within resource constraints is

critical to the organization's long-range

well-being. Capital budgeting techniques are

designed to enhance management's success in

making capital investment decisions.

Learning Objectives

How do managers choose which capital projects to

fund? Why do most capital budgeting methods rely

on analyses of cash flows? What are the

differences among payback period, the net present

value method, profitability index, and internal

rate of return? Why are quality management,

training, and research and development controlled

largely by capital budget analysis?

Learning Objectives

Why are environmental issues becoming an

increasingly important influence on the capital

budget? How and why should management conduct a

post-investment audit of a capital project? How

does ERP impact capital budgeting? What is the

time value of money? (Appendix 13B) How is the

accounting rate of return for a project

determined? (Appendix 13B)

Learning Objectives

How does capital cost allowance affect cash

flows? (Appendix 13C)

Capital Assets

Capital asset an asset used to generate

revenues or cost savings by providing production,

distribution, or service capabilities for

more than one year

Copy Machine

Lease

Capital Budgeting

Project future activity, such as the

purchase, installation, and operation of capital

asset

Capital budgeting the process of evaluating

long-range investment proposals for the purpose

of allocating limited resources effectively and

efficiently.

The Investment Decision

Despite technology and new tools, it is easy to

make the wrong decision when analyzing a new

project assump- tions may be faulty, and

different techniques will give different answers.

Capital Budgeting Questions

- Is the activity worth the investment?
- Which assets can be used for the activity?
- Of the suitable assets, which are the best

investments? - Screening decision
- Preference decision
- Which of the best investments should the company

choose? - Mutually exclusive projects
- Independent projects
- Mutually inclusive projects

Capital Budgeting Questions

Is the activity worth the investment?

Management initially measures an activity's worth

by monetary cost-benefit analysis. If an

activity's financial benefits exceed its costs,

the activity could be considered worthwhile. In

some cases, benefits cannot be measured in terms

of money. In other cases, it is known in advance

that the financial benefits will not exceed the

costs. In either of these situations an activity

meeting either of these criteria may still be

judged worthwhile for some qualitative reasons.

Capital Budgeting Questions

Which assets can be used for the activity? Part

of the decision process is a comparison of costs

and benefits. Managers should gather monetary and

nonmonetary information about each available and

suitable asset. This includes initial cost,

estimated life and salvage value, raw material

and labour requirements, operating costs (fixed

and variable), output capacity, service

availability and cost, maintenance expectations,

and revenues to be generated.

Capital Budgeting Questions

Of the suitable assets, which are the best

investments? There are two types of capital

budgeting decisions screening and preference.

If the project does not meet the minimum standard

requirement of the screening decision, it is

excluded from further consideration. Once

unacceptable projects have been screened out, a

preference decision is made in which the

remaining projects are ranked based on their

contributions to the achievement of company

objectives. Screening decision a judgment

regarding the desirability of a capital project

based on some previously established minimum

criterion or criteria Preference decision a

judgment regarding how projects are to be ranked

based on their impact on the achievement of

company objectives

Ranking Categories for Capital Projects

Category 1 Required by Legislation Safety

equipment and environmental protection equipment.

They may not meet the company's minimum

return criteria, but they are necessary Category

2 Essential to Operations without these

assets the primary functions of the organization

could not continue. Could include the

purchase of new capital assets, or replacement of

older capital assets Category 3 Nonessential

But Income Generating Capital assets that would

improve operations by providing cost savings or

supplements to revenue. Examples efficient

technology to replace labour Category 4

Optional Improvements Capital assets that do

not provide any cost savings or additional

revenues, but would make operations run more

smoothly or improve working conditions, for

example, a covered parking lot Category 5

Miscellaneous Pet projects of managers, for

example development of a new corporate logo or a

new executive washroom

Which of the Best Should the Company Choose?

Mutually exclusive projects a set of proposed

investments for which there is a group of

available candidates that all perform essentially

the same function or meet the same objective

from this group, one is chosen and all others are

rejected Independent projects an investment

project that has no specific bearing on any other

investment project Mutually inclusive project

a set of investment projects that must be chosen

as a package

Which of the Best Should the Company Choose?

Projects must be ranked in order to select the

ones that yield the highest value to the company.

Doing the analysis and ranking in the right way

pays off. A recent poll determined that 27.5 of

clients of the Institute of Management and

Administration saw changing the way they conduct

financial analysis of new projects as one of the

top ways to enhance corporate value.

Cash Flows

- Cash receipts and disbursements that arise from

the purchase, operation, and disposition of

capital assets. - Cash receipts
- project revenues that have been earned and

collected - savings generated by reduced project operating

costs - inflows from assets sale and release of working

capital at end of assets useful life - Cash disbursements
- expenditures to acquire the asset
- additional working capital investments
- amounts paid for related operating costs

Cash Flow the receipt or disbursement of cash

Cash Flows

Identify and include all cash flows relevant to

the project -- even if you have to use best

estimates. Only differential cash flows should

be used (relevant costs).

Interest is a cash flow created by the method

of financing a project.

Interest

It should not be considered in project evaluation.

Financing and Investing

Financing decision a judgment regarding how

funds will be obtained to make an acquisition

Investing decision a judgment regarding which

assets an entity will acquire to achieve its

stated objectives

Return of Capital vs. Return on Capital

Return of Capital recovery of the original

investment

Return on Capital income equals the discount

rate times an investment amount

Comparing the Techniques

Canada Oil Ltd. Truck Fleet Acquisition

Decision Purchase price of 20 trucks, trailers

and equipment 1,800,000 Cost of custom

modifications 600,000 Total cash

acquisition cost 2,400,000 Annual cash cost

of hiring freight forwarder 3,200,000 Annual

cash operating costs of company owned fleet

(2,600,000) Annual cash operating savings

600,000 Expected life of the trucks is six

years. At the end of the sixth year the trucks

are expected to have a salvage (residual) value

of 700,000.

Use a Timeline to Determine Cash Flows

Capital cost allowance tax depreciation Timelin

e illustration of the timing of expected cash

receipts and payments cash inflows are shown as

positive amounts and cash outflows are shown as

negative amounts Annuity a series of equal

cash flows occurring at equal time intervals

Use a Timeline to Determine Cash Flows

t0

Time

t1

t2

t3

t4

t6

t5

Net cash flow (2,400) 600 600 600

600 600 1,300

t0 (2,400) acquisition and modification

cost t1 to t5 600 annual operating

savings t6 1,300 year 6 operating

savings and inflow from sale of assets (residual

value)

Payback Period

Payback period the time required to recoup the

original investment in a project through its cash

flows

- The longer it takes to recover the initial

investment, the - greater is the projects risk
- Management sets a maximum acceptable payback

period - Often used as a screening technique

When a project provides an annuity, the payback

period equals the investment cost divided by the

amount of the projected annuity inflow. Canada

Oil's payback is four years (2,400,000 /

600,000).

Annuity a series of equal cash flows occurring

at equal time intervals

Payback Period

Company management typically sets a

maximum acceptable payback period as part of its

evaluation. Different categories of capital

projects may have different payback criteria.

Most companies use payback as only one of several

ways of judging an investment project usually

as a screening technique. Normally, after being

found acceptable in terms of payback period, a

project is subjected to evaluation by another

capital budgeting technique because of the

limitations of payback period.

Assumptions of Payback Period

- Speed of investment recovery is the key

consideration - Timing and size of cash flows are accurately

predicted - Risk (uncertainty) is lower for a shorter payback

project

Limitations of Payback

- Ignores cash flows after payback
- Basic method treats cash flows and project life

deterministically without explicit consideration

of probabilities - Ignores time value of money
- Cash flow pattern preferences are not explicitly

recognized - Ignores the company's desired rate of return

Discounted Cash Flow Methods

- Net present value (NPV)
- Profitability index (PI)
- Internal rate of return (IRR)

Discounted Cash Flow Methods -- Terminology

Discounting the process of removing the portion

of a future cash flow that represents interest,

thereby reducing that flow to a present value

amount Present value (PV) the amount that a

future cash flow is worth currently, given a

specified rate of interest Discount rate the

rate of return on capital investments required by

the company the rate of return used in present

value computations Cost of capital (COC) the

weighted average rate that reflects the costs of

the various sources of funds making up a firm's

debt and equity structure Net present value

method (NPV) an investment evaluation technique

that uses discounted cash flow to determine if

the rate of return on a project is equal to,

higher than, or lower than the desired rate of

return Net present value (PV) the difference

between the present values of all the project's

cash inflows and cash outflows Profitability

index (PI) a ratio that compares the present

value of net cash flows with the present value of

the investment Internal rate of return (IRR)

the discount rate at which the present value of

the cash inflows minus the present value of the

cash outflow equals zero

Discounted Cash Flow Methods

Money has a time value because interest is paid

or received on funds. 1,000 received today has

greater value than 1,000 received one year from

now. The 1,000 received today can be invested

and earn interest causing it to be more than

1,000 by the end of one year. Discounting is

based on two considerations the timing of

receipts or payments, and the assumed interest

rate. After discounting, all future values are

stated in a common base of current dollars, or

present values (PVs). Using present values of

future cash flows occurring at different points

in time allows managers to view all project

amounts in common terms (present values).

Discounted Cash Flow Methods

To discount the future cash flows, managers must

estimate the rate of return on capital required

by the company. This rate of return is

called the discount rate. It is used to

determine the imputed interest portion of future

cash flows. The discount rate should equal or

exceed the company's cost of capital. Current

expenditures (initial project investment) are

undiscounted. Because of this it is extremely

important for managers to obtain the best

possible information about future cash flows.

The amounts and timing of these future inflows

and outflows must be carefully estimated. Managers

need to consider ALL future cash flows those

that are obvious and those that are hidden.

Net Present Value Method

A discount rate may be adjusted up or down to

compensate for unique underlying factors in

investment projects. Managers of multinationals

may use a higher rate for international

investments to compensate for the greater risks

involved (foreign exchange fluctuations and

political instability). Managers may also raise

or lower the discount rate to compensate for

qualitative factors. For instance, an investment

in high-technology equipment that would provide

a strategic advantage over competitors might be

discounted at a rate lower than the COC.

Net Present Value Method

The NPV of a project is estimated by forecasting

the project's annual cash flows during its

expected life, discounting them back to the

present at a risk-adjusted rate, then

subtracting the initial start-up capital

expenditure. A project's net present value (NPV)

is the difference between the present values

of all the project's cash inflows and

outflows. The NPV of Canada Oil Ltd.'s estimated

cash flows (10 rate) is Discount

Present Description Time Amount

Factor Value Investment t0 (2,400,000)

1.0000 (2,400,000) Cash savings t1-t5

600,000 3.7908 2,274,480 Cash savings and

salvage t6 1,300,000 0.5645

733,850 Net present value 608,330

Net Present Value Method

Determines whether the rate of return (ROR) on

a project is equal to, higher than, or lower than

the desired ROR.

- May accept if
- If NPV 0, actual ROR desired ROR
- If NPV gt 0, actual ROR gt desired ROR
- May reject if
- If NPV lt 0, actual ROR lt desired ROR
- Does not determine expected ROR

Net Present Value Method

- Changing discount rate affects NPV
- Changing timing and size of cash flows affects

NPV - NPV can be used to select the best project when

choosing among investments that can perform the

same task or achieve the same objective - Like a roll of the dice, some cash flows,
- such as cost savings and revenue
- increases, are a gamble

Assumptions of Net Present Value

- Discount rate used is valid
- Timing and size of cash flows are accurately

predicted - Life of project is accurately predicted
- If the shorter-lived of two projects is selected,

the proceeds of that project will continue to

earn the discount rate of return through the

theoretical completion of the longer-lived project

Limitations of Net Present Value

- Basic method treats cash flows and project life

deterministically without explicit consideration

of probabilities - NPV does not measure expected rates of return on

projects being compared - Cash flow pattern preferences are not explicitly

recognized - IRR of project is not reflected

Profitability Index

a ratio that compares present value of net cash

inflows with the present value of the net

investment

- Compares projects with different costs
- PI should be at least equal to 1.0
- Gauges the firms efficiency at using its capital
- Does not indicate expected ROR

Profitability Index

Profitability Index (PI) NPV of future cash

flows / Net investment For Canada Oil Ltd.'s

project, PI is 3,009,330 / 2,400,000

approximately 1.25 3,009,330 2,274,480

733,850 (future cash flows)

Assumptions of Profitability Index

- Same as NPV
- Size of PV of net inflows relative to size of PV

of investment measures efficient use of capital

Limitations of Profitability Index

- Same as NPV
- Gives a relative answer but does not reflect
- dollars of NPV

Internal Rate of Return

- Internal rate of return the discount rate at

which the present value of the cash inflows minus

the present value of the cash outflows equals

zero - IRR is the projects expected rate of return.
- It is the discount rate where PV of net cash

flows the cost of the project. - Discount rate where NPV 0
- IRR is compared with the hurdle rate (which is

the lowest acceptable return on investment). - The project is acceptable if IRR gt hurdle rate.

Hurdle rate the rate of return deemed by

management to be the lowest acceptable return on

investment

Internal Rate of Return

Discount factor Investment/Annuity Assume a

project will cost 30,000 and will produce annual

net cash flows of 4,600 (annuity) for eight

years. Discount factor 30,000/4,600

6.5217 The present values of an ordinary annuity

(Table 2, Appendix C) will provide the internal

rate of return. The project's life is

eight years. In the row where n 8, look for

the discount rate. The factor corresponds to an

interest rate between 4 and 5 percent when the

number of periods is eight. The IRR is between 4

and 5 percent. (Note the factor at 4 is

6.7327 and the factor at 5 is 6.4632.)

Internal Rate of Return

When a project does not have equal annual cash

flows, finding the IRR involves an iterative

trial-and-error process. An estimate is made of

a rate believed to be close to the IRR, and the

NPV is computed. If the NPV is negative, a lower

rate is used and the process is repeated. If the

NPV is positive, a higher rate is tried. Canada

Oil Ltd. does not have equal annual cash flows.

The project has an expected IRR of more than

10, since discounting at that rate resulted in a

positive NPV. Using 18 results in a negative

NPV of 42,160. Using 17 results in a positive

NPV of 26,380. The IRR is between 17 and 18

percent.

Assumptions of IRR

- Hurdle rate is valid
- Timing and size of cash flows are accurately

predicted - Life of project is accurately predicted
- If the shorter-lived of two projects is selected,

the proceeds of that project will continue to

earn the IRR through the theoretical completion

of the longer-lived project

Limitations of IRR

- Projects are ranked for funding based on IRR

rather than dollar size - Does not reflect dollars of NPV
- Basic method treats cash flows and project life

deterministically without explicit consideration

of probabilities - Cash flow pattern preferences are not explicitly

recognized - It is possible to calculate multiple rates of

return on the same project

Prevention and Appraisal Costs and Capital

Budgeting

Control of quality has been discussed in terms of

managing four related costs internal failure,

external failure, appraisal, and prevention.

Total quality cost is the sum of costs in these

four categories. Management of quality costs

requires analysis of tradeoffs among the

categories. Spending greater amounts for

prevention and appraisal is likely to lead to

reduction in both failure cost categories. Preven

tion and appraisal costs are both partly managed

in the capital budget. Quality problems can be

prevented by acquiring more sophisticated

technology and by training workers to use

techniques that reduce errors. Statistical

quality controls can be applied to

monitor operations and determine when acceptable

error tolerances are exceeded.

Prevention and Appraisal Costs and Capital

Budgeting

A project with a negative NPV may still be

considered acceptable. If the new project would

reduce defects, the savings from reduced defects

should be included in the determination of NPV.

These savings can be significant and could

change the NPV to a positive figure. Investment

in training results in an increase in prevention

costs in the present, to be offset by future

decreases in other quality cost categories

external and internal failure.

Research and Development and Capital Budgeting

Research and development (R D) activities are

necessary to generate the innovative products and

services that will produce future revenues. Life

cycles of many products have decreased. Once an

innovative product reaches the market,

competitors can respond more quickly with

products that meet or exceed the quality and

features of the innovative product. In the race

to be first to market with a new product, each

week of delay can mean millions of dollars of

lost revenue and profit. In this competitive

game whose outcome depends on the pace of

introducing new products, the generation of

future profits critically depends on effective

capital budget analysis. R D requires a

commitment of cash and other resources in the

present to reap cash inflows in the future.

High-Tech Investments

The decisions are more a question of how much

and when than whether

Generally require massive monetary investment

Characteristics of High-Technology Capital

Projects

QUANTIFIABLE Material cost reduction Labour

savings Inventory reduction Scrap/waste

reduction Increased capacity

NON QUANTIFIABLE Setup reduction Elimination of

non-value-added activities (moves

inspections) Reduced manufacturing lead

time Reduced administration cycle time Increased

plant safety

FINANCIAL (shorter-term)

Characteristics of High-Technology Capital

Projects

QUANTIFIABLE Increased flexibility Improved

quality Increased market share due to new

product/innovation Price premiums due to shorter

lead times

NON QUANTIFIABLE Improved employee

morale Improved work environment Ability to

attract better employees Perceived technology

leadership Regulatory requirements are met

STRAGEGIC (longer-term)

Considerations in High-Tech Investment Analysis

- Discount or hurdle rate may need to be set lower
- Both quantitative and qualitative benefits need

to be considered - Reduced product development time
- Shortened delivery time
- Improved competitive position
- High-tech investments are not free-standing
- Opportunity cost of not acquiring automated

equipment is often critical

The Environment

Accounting for the future disposal cost of

products produced now and in the past North

American companies will likely be held

responsible for the ultimate reuse or proper

disposal of the products they produce. Companies

need to improve their identification and tracking

of current and future environmental

costs. Through improved measurement and

reporting of environmental issues and the impacts

related to product take-back, management

accountants can dramatically improve

decision making and corporate profitability.

Post-Investment Audit

a comparison of expected and actual project

results after a capital investment

- The process is intended to
- serve as an important financial control

mechanism - provide information for future capital

expenditure decisions - remove certain psychological and/or political

impediments usually associated with asset control

and abandonment - have a psychological impact on those proposing

capital investments

Post-Investment Audit

- A recent survey revealed the following.
- companies rate their capital investment planning

- process at 5.8 on a scale of 1 to 10 (10 being

best) - The reasons some companies are unhappy with their
- process are
- the process is subject to "gaming"
- certain capital investment (IT projects) get

special - treatment
- how executive incentive bonuses impact on
- investment decisions
- the way implementation and uncertainty risks are
- treated by the project appraisal process

Capital Budgeting with ERP System

- Capital budgeting can be done differently in

organizations with - functioning ERP systems. ERP systems are able to

integrate - all the subsystems including budgets and plans,

and - performance measures such as customer

satisfaction or an - entire balanced scorecard.
- ERP systems impact capital budgeting at three

stages - the capital project preparation and approval

stage, - the operational stage, and
- the post-audit stage.
- ERP systems allow capital projects to be modeled

as mini - independent businesses, i.e., as an investment

centre. These - models are used to analyze the projects. The

models - ascertain on an ongoing basis if the assumptions

were - validated. The models can do the post-audit.

Time Value of Money

Future value (FV) The amount to which one or

more sums of money invested at a specified

interest rate will grow over a specified number

of time periods Ordinary annuity an annuity in

which each cash flow occurs at the end of the

period Annuity due an annuity in which each

cash flow occurs at the beginning of the

period Annuity a series of equal cash flows

each cash flow of an annuity is called a

rent Present value (PV) the amount a future

cash flow is worth today Time value of money

problems (FV and PV) depend on three things the

amount of the cash flow(s), the rate of interest,

and the timing of the cash flow(s).

Appendix 13A

Interst Periods

NOTE Interest periods, rates, and rents MUST be

on a consistent basis.

Number of years X number of compounds number of

interest periods For example 5 years,

10, compounded semi-annually periods 5 X 2

10 rate 10 / 2 5

Appendix 13A

Interest Tables - PV

Table 1 (1) (i 10) n 1 .9091 n 2

.8265 n 3 .7513 Total 2.4868 Table 2

(Ord. Ann.) (i 10) n 3 2.4869

PV ?

0 1 2 3

1,000 1,000 1,000

Where n 3 i 10, the factor is 2.4869 PV

1,000 X 2.4869 2,4869

rounding

Appendix 13A

Time Value of Money

It is always helpful to draw a time line. If you

have the number of interest periods, the

interest rate, and one cash amount, you can find

the other cash amount. If you have the rate,

number of periods, and the rents, you can find

the present value, or the future value. If you

have the future value, the interest rate and

number of interest periods, you can find

the present value or the rents. In fact, if you

have the number of interest periods and the

present value and future value (or the rents),

you can find the interest rate. If you have the

interest rate and two of the cash values, you can

find the number of interest periods.

Appendix 13A

Accounting Rate of Return (ARR)

Accounting rate of return (ARR) Measures the

expected rate of earnings obtained on the average

capital investment over a projects life

- Not based on cash flows
- Compared with hurdle rate which may be higher

than the discount rate - Compared with ARR of other projects

Appendix 13B

Accounting Rate of Return (ARR)

ARR Average annual income from project

Average investment in project Investment in

project includes original cost and

project support costs, such as working capital

items (for example, inventory). Investment,

salvage value, and working capital released at

the end of the project's life are summed

and divided by two to obtain the average

investment.

Appendix 13B

Assumptions of ARR

- Effect on company accounting earnings relative to

average investment in a project is a key

consideration - Size and timing of investment cost, project life,

salvage value, and increases in earnings can be

accurately predicted

Appendix 13B

Limitations of ARR

- Ignores cash flows
- Ignores time value of money
- Treats earnings, investment, and project life

deterministically without explicit consideration

of probabilities

Appendix 13B

The Effect of Taxation on Cash Flows

Capital Cost Allowance (CCA) tax

depreciation Tax shield the amount of the

reduction of taxable income provided by Capital

Cost Allowance Capital Cost Allowance is not a

cash flow item. It is an allowable deduction

when computing taxable income. Therefore, by

reducing taxable income, taxes payable

is reduced. This reduction in taxes payable

improves cash flow. For example, if a company's

Capital Cost Allowance for the year is 300,000,

and their tax rate is 40, taxable income would

be reduced by the 300,000 and taxes payable

would be reduced by 120,000 (300,000 x .40).

The tax shield is 300,000 and the tax benefit is

120,000.

Appendix 13C

Capital Cost Allowance

The Income Tax Act allows for the deduction of

CCA using rates set by the government. Assets

are assigned to a class along with others which

are similar. The calculation of CCA is similar

to that for the declining balance method of

depreciation. A constant rate is applied to a

declining value. In the year of purchase the

asset is subject to the half-year rule the

amount of CCA that can be claimed is reduced to

one-half the amount in the year of

acquisition. When an asset is exchanged (traded

in), the excess of acquisition cost over trade-in

value is the amount subject to the half-year

rule. For tax purposes, assets are grouped into

classes. This allows for additions and disposals

without claiming gains or losses for tax purposes

until the last asset in the class is removed.

When the last asset is removed and the amount

received is less than book value a terminal loss

can be deducted in the calculation of taxable

income if the amount received is greater than

book value, the amount must be claimed as

Recaptured CCA. This increases taxable income.

Appendix 13C

Capital Cost Allowance

If an asset sells for more than its original

cost, a capital gain occurs. At this time, 50

of all capital gains are taxable at the

corporation's marginal tax rate. During the

first year of operation, CCA is pro-rated to

the portion of the year the corporation was in

business. Assets must be used during the year to

produce goods and/or services to qualify for CCA

deduction. In analyzing capital investments,

managers should be sure to use the most current

CCA regulations to calculate cash flows from

projects. CCA has a major impact on

after-tax cash flows, and therefore, on NPV. Tax

rate changes can cause actual outcomes to vary

from expected outcomes.

Appendix 13C

Using Tax Shield Formulae

Advanced Pipeline Monitoring System Data Summary

of data from Exhibit 10-9 Project

cost 640,000 Estimated life 8

years Estimated residual value

60,000 Increase in annual operating net cash

flow (80,000 25,000) 105,000 Tax

rate 38 Increase in cash flow (after

tax) 65,100 105,000 X (1-.38) Discount

rate 12 Minimum payback period

5 years Capital Cost Allowance rate (class 10)

30 UCC at the end of year 8 (64,001 -

19,200) 44,801

UCC at the beginning of year 8 Year 8 UCC

UCC at the end of year 8 UCC undepreciated

capital cost

Appendix 13C

PV of the Tax Shield

Net present value of after-tax cash flows can be

calculated using the formulae. Step 1.

Calculate the present value of the tax

shield. Cdt / (dk) x (1 0.5k) / (1

k) C capital cost of the asset d CCA

rate t marginal tax rate k cost of

capital (1 0.5k) / (1 k) the correction

factor for the half-year rule

Appendix 13C

PV of the Tax Shield

Cdt / (dk) x (1 0.5k) / (1 k) 640,000

X 0.30 X 0.38 / (0.30 0.12) X 1 (0.5 X

0.12) / (1 0.12) (72,960 / 0.42) X

0.94642 173,714.28 X 0.94642 164,408.40

Step 2. Calculate the present value of salvage

value to be received at the end of the

project. 60,000 X 0.4039 24,234

Appendix 13C

PV of Tax Shield Year 8

Step 3. The CCA tax shield will be reduced

because the total value of the pool will be

smaller. The CCA tax shield formula must be

adjusted by deducting the present value of the

tax shield in year 8 when the asset is

removed. Sdt / (d k ) X 1 / (1

k)n Where S undepreciated capital cost Where

n estimated life (44,801 X 0.30 X 0.38) /

(0.30 0.12) X (1 / 2.4760) 4,911.26

44,801 is UCC at the end of year 8. In step 1,

the tax shield was calculated on the total cost

of the investment. However, by the end of year

8, you had not deducted 44,801 for tax purposes.

Therefore you must now reduce the amount of tax

benefit for this amount.

Appendix 13C

PV of After-Tax Cash Flow of Disposal

Step 4. The present value of the after-tax cash

flow from the sale of the equipment at the end

of its life (60,000 - 44,801)(0.50) X

0.38 X 0.4039 1,166 Step 5. Calculate the

NPV of the project PV of operating cash flows

(65,100 X 4.9676) 323,391 PV of tax shield

(from Step 1) 164,408 PV of salvage (from

Step 2) 24,234 Less PV of lost tax

savings (Step 3) (4,911) Less PV of

recapture (Step 4) (1,166) Less

Original cash outlay (640,000) Net Present

Value of Cash Flows (134,045)

Appendix 13C

The End