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Title: Capital Cost Allowance (CCA) tax depreciation Tax shield


1
Capital Asset Selection and Capital Budgeting
Chapter 13
2
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.
3
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?
4
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)
5
Learning Objectives
How does capital cost allowance affect cash
flows? (Appendix 13C)
6
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
7
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.
8
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.
9
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

10
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.
11
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.
12
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
13
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
14
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
15
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.
16
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
17
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).
18
Interest is a cash flow created by the method
of financing a project.
Interest
It should not be considered in project evaluation.
19
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
20
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
21
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.
22
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
23
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)
24
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
25
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.
26
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

27
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

28
Discounted Cash Flow Methods
  • Net present value (NPV)
  • Profitability index (PI)
  • Internal rate of return (IRR)

29
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
30
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).
31
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.
32
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.
33
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
34
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

35
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

36
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

37
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

38
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

39
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)
40
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

41
Limitations of Profitability Index
  • Same as NPV
  • Gives a relative answer but does not reflect
  • dollars of NPV

42
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
43
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.)
44
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.
45
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

46
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

47
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.
48
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.
49
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.
50
High-Tech Investments
The decisions are more a question of how much
and when than whether
Generally require massive monetary investment
51
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)
52
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)
53
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

54
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.
55
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

56
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

57
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.

58
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
59
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
60
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
61
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
62
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
63
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
64
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
65
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
66
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
67
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
68
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
69
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
70
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
71
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
72
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
73
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
74
The End
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