Chapter 14 - Cash Flow Estimation and Capital Budgeting Decisions

Prepared by
Ken Hartviksen

INTRODUCTION TO
CORPORATE FINANCE
Laurence Booth W. Sean Cleary

Chapter 14 Cash Flow Estimation and
Capital Budgeting Decisions
CHAPTER 14
Cash Flow Estimation and
Capital Budgeting Decisions
CHAPTER 14 Cash Flow Estimation and Capital Budgeting
Decisions
14 - 3
Lecture Agenda
Learning Objectives
Important Terms
General Guidelines for Capital Project Analysis
Estimating and Discounting Cash Flows
Sensitivity to Inputs
Replacement Decisions
Inflation and Capital Budgeting Decisions
Summary and Conclusions
Concept Review Questions
Appendix 1 Company A
Appendix 2 Backus Distributing Limited
Decisions
14 - 4
Learning Objectives
1. How to estimate the future cash flows associated with potential
investments
2. How to determine whether these investments are the result of
expansion or replacement decisions
3. How to conduct a sensitivity analysis to see how the value changes
as key inputs vary
4. Why real option valuation techniques have become an important
trend in project evaluation
5. How mistakes can easily be made in dealing with inflation
Decisions
14 - 5
Important Chapter Terms
Capital cost (C
0
)
Decision tree
Ending (or terminal) after-
tax cash flow (ECF
n
)
Expansion projects
Expected annual after-tax
cash flows (CF
t
)
Externalities
Initial after-tax cash flow
(CF
0
)
Marginal or incremental
cash flows
NPV break-even point
Opportunity costs
Real option valuation (ROV)
Replacement projects
Salvage value (SV
n
)
Scenario analysis
Sensitivity analysis
Sunk costs

Relevant Cash Flows for Capital
Project Evaluation
Cash Flow Estimation and Capital
Budgeting Decisions
Decisions
14 - 7
Cash Flows and Capital Budgeting
Introduction
Decisions are only as good as the information used
to make them.
This chapter focuses on approaches used to
estimate future cash flows associated with capital
project proposals
Decisions
14 - 8
Project Evaluation Techniques
Required Information and Estimates
All evaluation approaches (NPV, IRR, Discounted Payback, and PI)
require the same data:
Estimate of initial cost (CF
0
)
Net incremental after-tax cash flows CFBT(1-T)
Cost of Capital (k)
Estimate of useful life (n)
Ending Cash flows (ECF
n
)
Corporate tax rate (T)
Capital Cost Allowance Rate (d)
This chapter provides you with guidelines for identifying relevant
information and testing the decisions sensitivities to variations in
those input variables.

Decisions
14 - 9
Cash Flows Estimation
General Guidelines
Cash flows should be:
1. After-tax
2. Incremental or marginal
3. Do not include interest or dividends
4. Adjust initial cash outlay and terminal cash flows for additional working
capital requirements
5. Treat sunk costs as irrelevant
6. Opportunity costs should be factored into the cash flow estimates

Determine the appropriate time horizon for the project
Ignore intangible considerations
Ignore externalities
Consider the effect of all project interdependencies on cash flow
estimates.
Treat inflation consistently
Undertake all social investments required by law.

Decisions
14 - 10
The Capital Budgeting Cash Flows
The Basic Cash Flow Pattern
The following slide graphically illustrates the basic
cash flow patterns involved in a capital project:
There is an initial investment at t = 0 (CF
0
)
There follows an annual stream of after-tax cash flow benefits
(CF
t
)
At the end of the useful life, ending cash flow benefits after tax
are received (ECF
n
)
) ( ) (
0
CF ECF PV CFs Annual PV NPV
n
+ = [ 14-5]
Decisions
14 - 11
The Basic Cash Flow Pattern
Initial After-
Tax Cash Flow
(CF
0
)
Expected Annual After-Tax Operating Cash Flows (CF
tt
)
t=1 2 3 n-1 n
CF
1
CF
2
CF
3
CF
N-1
CF
N

Terminal Cash
Flow (ECF
n
)
=
+
=
n
t
t
t
t
k
CF
CF of PV
1
) 1 (
If CF
0
< PV of
CF
t
, then
benefits
exceeds costs,
the NPV is
positive.
ACCEPT the
Project
Decisions
14 - 12
Deconstructing the Basic Cash Flow Pattern
The basic cash flow pattern can be deconstructed
into:
Initial investment (CF
0
)
Annual stream of after-tax cash flows throughout the
project life (CF
t
)
Ending cash flows (ECF
n
)
Decisions
14 - 13
CF
0

There is an initial investment at t = 0 (CF
0
) consists of:
C
0
the initial capital cost of the asset
NWC
0
the change in net working capital
OC the opportunity costs associated with the project

0 0 0
OC NWC C CF + A + =
[ 14-1]
Decisions
14 - 14
CF
t

There follows an annual stream of after tax cash flow
benefits (CF
t
) consisting of:
Operating after-tax cash flow benefits (OCF
t
) = CFBT
t
(1 T)
Tax shield benefits from CCA

) ( ) 1 ( T CCA t CFBT CF
t t t
+ + =
[ 14-2]
Decisions
14 - 15
ECF
n

At the end of the useful life, ending cash flow benefits received
(ECF
n
) in the absence of tax issues include:
SV
n
the estimated salvage value in year n for the asset purchased
NWC
n
the net working capital investment released at the end of
the project

NWC SV ECF
n n n
A + =
[ 14-4]
Decisions
14 - 16
ECF
n

If there are tax issues the ECF
n
consists of:
SV
n
the estimated salvage value in year n for the asset purchased
NWC
n
the net working capital investment released at the end of
the project
Less any taxes payable on the salvage value (capital gains,
recapture of depreciation)

] ) -
T] 50 . 0 ) C - [( ns) Implicatio Tax With (
0
T UCC [(SV
SV NWC SV ECF
n n
n n n n

A + =
[ 14-3]
Decisions
14 - 17
Putting It All Together

Once you have estimated the cash flows you must:
Determine their after-tax values
Discount them back to the present
Sum them in determining the NPV

(The following slide graphically illustrates the deconstructed cash flow pattern involved in a capital project)
Decisions
14 - 18
Deconstructing the Cash Flows

Initial After-
Tax Cash Flow
(CF
0
)
Expected Annual After-Tax Operating Cash Flows (excluding CCA Tax
Shield) (OCF
t
) = CFBT(1 T)
t=1 2 3 n-1 n
CF
1
CF
2
CF
3
CF
N-1
CF
N

Terminal Cash
Flow (ECF
n
)
CF
0
= C
0
+ NWC
0
+ OC
Expected Tax Shield Benefits from CCA deduction (CdT)
=
+
=
n
t
t
t
t
k
CF
CF of PV
1
) 1 (
Because the CCA
tax shield benefit
changes each year
in a predictable
fashion, we can
use a formula to
calculate their total
present value.
Decisions
14 - 19
Alternative Approaches to Finding the Tax
Shield Benefit on CCA
You will recall that there are two approaches to
determining cash flows.
We will use alternative (2) found on Table 14 1
This allows us to deconstruct the analysis,
separating operating cash flows from the tax shield
benefits of CCA.

(See the following slide)
Decisions
14 - 20
Determining Cash Flows after CCA
(1) Before-tax operating Income (OI) (2) Before-tax Operating Income (OI)
- CCA - Taxes payable on OI
Taxable Income After-tax OI
-Taxes Payable + CCA tax savings
After-tax Income Net Cash Flow
+ CCA (non-cash expense)
Net Cash Flow
Table 14 - 1 Two Ways to Determine Cash Flows After Capital Cost Allowance
Present Value of Tax Savings on
Capital Cost Allowance
Budgeting Decisions
Decisions
14 - 22
Separating Operating Cash Flows from
CCA Tax Shield Benefits

t=1 2 3 n-1 n
CF
1
CF
2
CF
3
CF
N-1
CF
N

Typically operating cash
flow benefits can be treated
as an annuity.
The CCA Tax Shield
benefits are a growing
perpetuity with a constant
negative growth rate.
The only exception to this
is the first cash flow. (This
is year rule effect.)
Decisions
14 - 23
Tax Shield Benefit of CCA
The tax shield benefit from CCA is equal to the corporate tax
rate (T) CCA amount.
As demonstrated in the following slide, assuming the firm will
have taxable operating income in the future, we can predict
the maximum amount of CCA the firm can claim from the year
of acquisition through to infinity.
You will note:
rule effect in the first year
We assume we claim the maximum CCA in each subsequent
year.
We forecast the tax shield benefit by: T CCA
t

Tax shield benefits will be a perpetual stream of cash flows that
are going a constant negative compound growth rate (d) where d
is the CCA rate
Decisions
14 - 24
CCA Tax Shield Over Time
(Assume a corporate Tax Rate T of 40%)
Year UCC of pool Addition CCA @ 10% T(CCA)
1 0 100,000 5,000 2,000
2 95,000 0 9,500 3,800
3 85,500 0 8,550 3,420
4 76,950 0 7,695 3,078
5 69,255 0 6,926 2,770
6 62,330 0 6,233 2,493
7 56,097 0 5,610 2,244
8 50,487 0 5,049 2,019
9 45,438 0 4,544 1,818
$100,000 asset is acquired in year 1.
No asset pool disposals. CCA rate
(d) = 10%
Tax Shield = T(CCA)
Lets
graph
this
series of
tax
shield
benefits
the firm
is
forecast
to
receive.
Decisions
14 - 25
(A Graphical Representation)
0
500
1000
1500
2000
2500
3000
3500
4000
Tax Shield
1 3 5 7 9 11 13 15 17 19
Year
T(CCA) at 10% on $100,000
Asymptotic
Curve
Decisions
14 - 26
Observations
In the foregoing you can now readily see:
CCA provides large tax shields in the early years of the
assets life
residual values remain in the pool long after the asset was
acquiredthis means that the firm will never fully recoup the
original cost of the asset as the firms asset base ages,
cash flows generated from CCA will not enable the firm to
replace the original asset.

Now we can learn how to find the present value of a perpetual
stream of forecast cash flows.

Decisions
14 - 27
Present Value of the CCA Tax Shield
(Assume a corporate Tax Rate T of 40% and Discount rate of 12%)
(1) (2) (3) (4) (5) (6) = (4) (5)
Year UCC of pool Addition CCA @ 10% T(CCA)
Present
Value
Factor at
12%
Present
Value
1 0 100,000 5,000 2,000 0.893 $1,786
2 95,000 0 9,500 3,800 0.797 3,029
3 85,500 0 8,550 3,420 0.712 2,434
4 76,950 0 7,695 3,078 0.636 1,956
5 69,255 0 6,926 2,770 0.567 1,572
6 62,330 0 6,233 2,493 0.507 1,263
7 56,097 0 5,610 2,244 0.452 1,015
8 50,487 0 5,049 2,019 0.404 816

Sum (1:8) = $13,871
This is the sum of the first 8 years of tax savingsit would be an infinitely
long process to find the actual sum of an infinite stream of cash flows.

We must develop a formula-based solution to this problem.
Multiplying T(CCA) by the PVIF we can estimate the present
value of the tax shield benefit for each year into the future.
Decisions
14 - 28
In Chapter 7 you learned about the constant growth DDM:

This model assumes the first dividend becomes the base
amount and all future cash flows grow at a constant
compound rate from t =1 through infinity:

g k
D
g k
g D
P
c c

=
+
=
1 0
0
) 1 (
[ 7-7]
o
o
) 1 (
) 1 (
...
) 1 (
) 1 (
) 1 (
) 1 (
0
2
2
0
1
1
0
0
c c c
k
g D
k
g D
k
g D
P
+
+
+ +
+
+
+
+
+
= [ 7-6]
Decisions
14 - 29
The constant growth DDM:

The Tax Shield benefit to CCA (ignoring the year rule for a
moment) is the same except:
Cash flow at time one is the CCA tax shield at t = 1 and is calculated as
(TdC
0
) this is the numerator
The growth is negative (declining balance) two negatives equal a
positive!

1
0
g k
D
P
c

=

) (
) )( )( (
) (
0 0

d k
dT C
d k
T d C
Shield Tax CCA PV
+
=

=
Decisions
14 - 30
Present Value of Tax Savings Lost on
Salvage Value an ECF
We will use this version of the formula to calculate the
present value of tax savings lost on the salvage value of
the asset (when the net addition rule does not apply)
The PV of tax savings lost at time n =

) (
) )( )( (

d k
dT SV
d k
T d SV
Value Salvage on Lost Shield Tax CCA of PV
n n
n
+
=

=
Decisions
14 - 31
Present Value of Tax Savings Lost on
Salvage Value an ECF
The PV of tax savings lost at time n =

The last step in finding the Present value of this amount is to
discount the value back to t = 0.
Sothe equation becomes:

) (
) )( )( (
1

d k
dT SV
d k
T d SV
n n
n
+
=

=

k) (1
1
) 1 (
) (
) )( )( (
n 0

d k
dT SV
k
d k
T d SV
n
n
n
+
+
=
+

=
Decisions
14 - 32
Present Value of the Tax Savings on CCA
Assuming the Year Rule
Adjusting the Formula for the year Net Addition Rule

We multiply the first factor by (1+.5k) / (1+ k) to produce a formula
that will estimate the present value of tax savings from CCA (time 1
through infinity) assuming year net addition rule.
For a graphical depiction of this formula see the following slide.

1
5 0 1
) (
0

k
)k . (
d k
dT C
Shield Tax CCA PV
(
+
+
+
=
Decisions
14 - 33
0
500
1000
1500
2000
2500
3000
3500
4000
Tax Shield
1 3 5 7 9 11 13 15 17 19
Year
T(CCA) at 10% on $100,000

1
5 0 1
) (
0

k
)k . (
d k
dT C
Shield Tax CCA PV
(
+
+
+
=
This formula
calculations
the PV of tax
savings on
CCA from time
1 through
infinity
assuming the
year net
addition rule.
Decisions
14 - 34
Present Value of the Tax Savings on CCA
Adjusting for Year Rule An Example
We can now use the formula to solve for the present of the tax
savings on CCA for an asset that is never sold (no salvage value):

This formula assumes:
C
0
= $100,000 (Initial cost of a depreciable asset)
d = 10% (CCA rate)
k = 12% (Cost of capital or discount rate)
T = 40% (Corporate tax rate)
Notice the answer is greater than the spread sheet example ($13,871)
because the spreadsheet summed only the first 8 cash flows whereas the
formula finds the sum of the present values of the tax shield benefits for an
infinite stream.

27 . 207 , 17 $
12 . 1
06 . 1
22 .
000 , 4 $
12 . 1
) 12 (. 5 . 1
1 . 12 .
) 4 )(. 1 (. 000 , 100 $
1
5 0 1
) (
0

k
)k . (
d k
dT C
Shield Tax CCA PV = =
(
+
(
+
=
(
+
+
+
=
Decisions
14 - 35
Formula for PV of Tax Savings on CCA
Assuming a Salvage Value at t = n
Finally we can incorporate planned disposal of the
asset we will acquire.

Disposal value is the salvage value (SV) at t = n

(See the following two slides for graphical depiction of the effect of a salvage value)

) 1 (
1
) (
) )( )( (
) 1 (
) 5 . 0 1 ( ) )( )( (
) (
0

k k d
T d SV
k
k
k d
T d C
Shield Tax CCA PV
n
n
+
+
+
+
=
[ 14-7]
Decisions
14 - 36
0
500
1000
1500
2000
2500
3000
3500
4000
Tax Shield
1 3 5 7 9 11 13 15 17 19
Year
T(CCA) at 10% on $100,000 By selling the
asset after the end
of the 10
th
fiscal
year, we lose CCA
in years 11
through infinity.
( )

1
1
) (
0

k d k
dT SV
SV on Lost Savings Tax CCA PV
n
n
(
+
=
Decisions
14 - 37
0
500
1000
1500
2000
2500
3000
3500
4000
Tax Shield
1 3 5 7 9 11 13 15 17 19
Year
T(CCA) at 10% on $100,000
( )

1
1
) 1 (
) 5 . 1 (
) (
0
0

k d k
dT SV
k
k
d k
dT C
Savings Tax CCA PV
n
n
(
+
+
+
=
We subtract the
PV of tax savings
lost on the
Salvage Value
from the PV of tax
saving from t = 1
through infinity to
get the PV of tax
savings benefits
years 1 10.
Operating Cash Flows
Budgeting Decisions
CFBT
t
(1-T)
Decisions
14 - 39
Expected Annual After-Tax Cash Flows
(CF
t
)
As illustrated in Equation 14 2 expected Annual
After-Tax Cash Flows are:
The cash flows that are estimated to occur as a result of the
investment decision, comprising
the associated expected incremental increase in after-tax
operating income and
Any incremental tax savings (or additional taxes paid) that result
from the initial investment outlay.
t t t
+ + =
[ 14-2]
Decisions
14 - 40
Forecasting Expected Annual After-Tax
Cash Flows (CF
t
)
Example 14 - 2 from your text
Approach 1
Year 1 Year 2 Year 3 Year 4 Year 5
Operating Income $125,000 $125,000 $125,000 $125,000 $125,000
- CCA Expense -97,500 -165,750 -116,025 -81,218 -56,852
Taxable Income $27,500 -$40,750 $8,975 $43,782 $68,148
- Taxes payable @ 45% 12,375 -18,338 4,039 19,702 30,667
After-tax income $15,125 -$22,413 $4,936 $24,080 $37,481
+ CCA expense $97,500 $165,750 $116,025 $81,218 $56,852
Net cash flow $112,625 $143,338 $120,961 $105,298 $94,333
Approach 2
Year 1 Year 2 Year 3 Year 4 Year 5
Operating Income $125,000 $125,000 $125,000 $125,000 $125,000
- Taxes Payable on Operating
income @ 45% 56250 56250 56250 56250 56250
After-tax Operating Income $68,750 $68,750 $68,750 $68,750 $68,750
+ CCA tax savings (CCA * T) 43,875 74,588 52,211 36,548 25,583
Net cash flow $112,625 $143,338 $120,961 $105,298 $94,333
Spreadsheets
can be useful in
making detailed
forecasts of the
incremental
operating cost
and benefits
associated with
the project.
Operating
cash flows are
an annuity
where as net
cash flow is
not.
Decisions
14 - 41
Decomposing Expected Annual After-Tax
Cash Flows (CF
t
)
We have already seen that since the CCA tax
shield (CCA
t
)(T) changes each year and potentially
involve an infinite series, we separately calculate
its present value using a formula.
t t t
+ + =
[ 14-2]
Decisions
14 - 42
Decomposing Expected Annual After-Tax
Cash Flows (CF
t
)
Since the operating cash flow benefits after-tax are
often equal each year, we can find their present
value simply using the Present Value Factor of an
Annuity:

) 1 (
1
1
) 1 ( ) (
k
k
T CFBT Flows Cash Operating PV
n
(
(
(
(
=
[ 14-6]
Decisions
14 - 43
Decomposing Expected Annual After-Tax Cash
Flows (CF
t
)
Example of the PV of the Operating Cash Flow Annuity
Using Example 14 2:
Operating income
excluding CCA before tax =
$125,000
Tax rate = 45%
Useful life = 5 years
Discount rate (k) = 10%
The present vale of the
operating income annuity =
616 , 260 $ 7908 . 3 750 , 68 $

.1
(1.1)
1
- 1
.45) - $125,000(1

) 1 (
1
1
) 1 ( ) (
5
= =
(
(
(
(
=
(
(
(
(
=
k
k
T CFBT Flows Cash Operating PV
n
Ending (or Terminal) Cash Flows
Budgeting Decisions
ECF
n

Decisions
14 - 45
Ending (or Terminal) After-Tax Cash
Flows (ECF
n
)
Ending cash flows include:
Salvage value of the asset (SV
n
)
Recovery of the net investment in working capital (NWC
n
)
Less any taxes payable in the event of a capital gain on the sale of the
asset or a recapture of depreciation.
] ) -
T] 50 . 0 ) C - [( ns) Implicatio Tax With (
0
T UCC [(SV
SV NWC SV ECF
n n
n n n n

A + =
[ 14-3]
Decisions
14 - 46
CCA Tax Shield with a Recapture of
Depreciation
Equation 14 -8 Is used when the salvage value of the asset is
greater than the UCC of the pool of assets at the time of disposal.
A recapture of depreciation must be included in income in the year it
occurs and is subject to tax at the firms tax rate (T )

) 1 (
) )( (
) 1 (
1
) (
) )( )( (
) 1 (
) 5 . 0 1 ( ) )( )( (
) (
0

k
T UCC SV
k k d
T d SV
k
k
k d
T d C
Shield Tax CCA PV
n
n n
n
n
+
+
+
+
=
[ 14-8]
Decisions
14 - 47
Capital Gain on Asset Disposal
Equation 14 9 is used when you expect to sell the asset for a price
that is greater than its original cost.
The difference between the SV and C
0
is the capital gain.
50% of a realized capital gain is subject to tax at the corporate tax
rate (T )

) 1 (
) )( 5 )(. (
) (
0

k
T C SV
Paid Taxes Gains Capital PV
n
n
+
=
[ 14-9]
Decisions
14 - 48
NPV Using the Decomposed
Components
Equation 14 10 show how the decomposed components are
recombined to determine the projects NPV.
Remember NPV =
+ Present value of after-tax operating cash flows
+ Present value of CCA tax shield
+ Present value of the salvage value (ECF)
+ Present value of the recovery of net working capital investment (ECF)
- Taxes payable on realized capital gain and/or recapture of depreciation (ECF)
- Initial investment in the asset (CF
0
)
- Initial investment in net working capital (CF
0
)

) (
) ( ) ( ) (
0
CF Paid Taxes Gains Capital PV
ECF PV Shield Tax CCA PV CFs Operating PV NPV
n

+ + =
[ 14-10]
Sensitivity of Decision to Input
Variables
Budgeting Decisions
Decisions
14 - 50
Sensitivity Analysis
Stress testing NPV models to determine the
sensitivity of the decision to input variables is an
important part of risk assessment.

There are two common approaches:
Sensitivity analysis
Scenario Analysis
Decisions
14 - 51
Sensitivity Analysis
Sensitivity analysis is an examination of how an
investments NPV changes as the value of one input
at a time is changed.
Decisions
14 - 52
Scenario Analysis
Scenario analysis is an examination of how an investments
NPV changes in response to varying scenarios in terms of one
or more estimates, such as sales or costs.

Input variables are often given discrete forecast ranges:
Best case
Most likely
Worst case

The analyst will be interested in what the NPV might be in the
worst combination of cases for example:
Worst case operating cash flows (low)
Worst case initial cost (high)
Worst case new working capital investment (high)
Real Option Valuation (ROV)
Budgeting Decisions
Decisions
14 - 54
ROV and decision tree analysis have dramatically increased understanding of
corporate decision-making and the value of flexibility and strategic
considerations.

Decision trees are a schematic way to represent alternative decisions and the
possible outcomes.

Table 14 -2 (next slide) gives a real options example of three alternative ore-
price scenarios for a mine. (The most important variable in mining projects).

This table illustrates that the highest expected cash flows occur when ore
prices are most volatile (have the greatest range of prices).

This illustrates an option that is often overlooked in traditional project
analysisthe possibility of shutting down the mine when prices make it
uneconomic. (Remember, the mine can be returned to production when
economic conditions turn more favourable.)
Decisions
14 - 55
Comparing NPV and IRR
Scenario 1:
Ore Price
$12 or $8
Scenario 2:
Ore Price
$14 or $6
Scenario 2:
Ore Price
$14 or $6
Good price (=.5) $12 $14 $16
Cash Flow $400 $600 $800
Bad price (=.5) $8 $6 $4
Cash Flow $0 -$200 -$200
Expected cash flow $200 $200 $300
Table 14 - 2 Real Options Example
NPV Break-Even Analysis
Budgeting Decisions
Decisions
14 - 57
NPV Break-Even Analysis
Operating Cash Flow NPV Break-even Point
Solving for the annual operating after-tax cash
flows that cause NPV = 0.
PV (Operating CFs) is the source of value creation
The most important part of the viability analysis.

Decisions
14 - 58
Operating Cash Flow NPV Break-Even Point
Example:
CF
0
= $100,000
PV(CCA Tax Shield) = $20,453
PV(ECF
n
) = $12,834
Approach:
Set NPV = 0 and solve for the
PV of the operating CF
s
:
Now solve for the annual after-
tax CF
Conclusion:
The operating cash flows could
fall to $10,770 without
destroying value.
Now the decision makers can
assess the threats to this key
forecast and determine the
likelihood of this occurring.
713 , 66 $ ) (
000 , 100 $ 834 , 12 $ 453 , 20 $ ) ( 00 . 0 $
) ( ) ( ) (
0
=
+ + =
+ + =
CFs Operating PV
CFs Operating PV
CF ECF PV Shield Tax CCA PV CFs Operating PV NPV
n
770 , 10 $
) 194374 . 6 ( ] [ 713 , 66 $

12 . 0
) 12 . 1 (
1
1
] [ ) (
12
=
=
=
CF Operating even Break
CF Operating even Break
CF Operating even Break CFs Operating PV
Decisions
14 - 59
Operating Cash Flow NPV Break-Even Point
NPV
$
$20,000
Operating Cash Flow
Break-even cash flow
0
$50,000 $40,000 $30,000 $20,000 $10,000 $0
It is possible to vary the cash
flow assumptions and test
the sensitivity of NPV to
those changes.

NPV is the dependent
variable.
Decisions
14 - 60
NPV Break-Even Discount Rate
Break Even Discount Rate
IRR of the project
NPV profile illustrates the range of discount rates
that produce a positive NPV.

(See the following two slides as a review of NPV profiles from Chapter 13)

Decisions
14 - 61
NPV
$
$260,000
Discount Rate (%)
IRR = 55.8%
0
0% 5% 10% 20% 40% 50% 60%
Required rates of return
can change if:
The general level of
interest rates rise in
the economy, or
The risk of the project
increases.
Decisions
14 - 62
NPV
$
$260,000

$146,684
Discount Rate (%)
IRR = 55.8%
0
0% 5% 10% 20% 40% 50% 60%
Even if your estimate of the
projects required return (RADR)
is wrong, the projects NPV
remains positive over a wide
range of values for k (from 0% to
55%)
Expansion and Replacement Decisions
Budgeting Decisions
Decisions
14 - 64
Expansion Decisions
Expansion projects add something extra to the firm in
terms of sales or cost savings.

Their new cash flows are incremental cash flows.
Decisions
14 - 65
Involve the replacement of an existing asset (or
assets) with a new one.
In such cases we must clearly identify the
incremental cash flows paying particular attention to:
The effect on the incremental capital cost (C
0
)
The effect on the CCA tax shield

Decisions
14 - 66
Incremental Capital Cost

Incremental Capital Cost (C
0
) = the difference between
the purchase price of the new equipment and the
salvage price of the old machine.

The equipment to be replaced is normally sold. Normally there are
no tax consequences on disposal, except when assets are sold
at a price greater than their original cost (which triggers capital
gains taxes on the difference)
Decisions
14 - 67
Effects on Capital Cost Allowance Tax Shield

When an asset is removed from the Capital Cost Allowance Class:
There is no CCA in the year of disposal
The UCC of the pool/class is reduced by the disposal value
When an asset is added to the Capital Cost Allowance Class:
There is of the normal CCA on the net additions to the pool in
that year
The UCC of the pool is increased by half of the net addition in the
first year, and half of the net additions in the second year.

In replacement decisions we must modify the PV of Tax Shield
formula to account for the change () in C
0
and () in SV

(See the following slide for the new formula)

Decisions
14 - 68
Effects on Capital Cost Allowance Tax Shield

) 1 (
1
) (
) )( )( (
) 1 (
) 5 . 0 1 ( ) )( )( (
) (
0

k k d
T d SV
k
k
k d
T d C
Shield Tax CCA PV
n
n
(
+
A
+
+
+
A
= A
The replacement of old with new results in a change
in the tax shield and affects both the net cost of the
new as well as the salvage value.
Decisions
14 - 69
Simple Example Ignoring CCA Formula Approach
Problem:
Cost of new machine =
$12,000
Disposal value of old
machine = $2,000

After-tax cash flow benefits:
Year 1 = $5,000
Year 2 = $5,000
Year 3 = $8,000
Discount rate (k) = 15% 389 , 3 $
000 , 10 $ 260 , 6 $ 781 , 3 $ 348 , 4 $
) 000 , 2 $ 000 , 12 ($
) 15 . 1 (
000 , 8 $
) 15 . 1 (
000 , 5 $
) 15 . 1 (
000 , 5 $

) 1 ( ) 1 ( ) 1 (

3 2 1
0
3
3
2
2
1
1
=
+ + =
+ + =
A
+
+
+
+
+
= C
k
CF
k
CF
k
CF
NPV
Incremental
capital cost is
the price of the
new machine
less the price of
the old.
Decisions
14 - 70
Simple Example Ignoring CCA Formula Approach
Incremental Cost (new-old) = $10,000
Cost of Capital = 15.0%
Year Cashflow
After-tax
incremental CF PV Factor
Present
Value
0 Initial cost -$10,000 1 -$10,000
1 ATCF operating benefit 5,000 0.869565 $4,348
NPV = $3,389
Problem:
Cost of new machine = $12,000
Disposal value of old machine =
$2,000

After-tax cash flow benefits:
Year 1 = $5,000
Year 2 = $5,000
Year 3 = $8,000
Discount rate (k) = 15%
Decisions
14 - 71
The Formula Approach
The deconstructed NPV model can be used in
replacement decisions.

Again, in replacement decisions, the focus in on the net
change in operating cash flows, net change in CCA tax
shield, and net changes in ending and initial cash flows.
) ( ) ( ) (
0
CF ECF PV Shield Tax CCA PV CFs Operating PV NPV
n
A A + A + A =
Inflation and Capital Budgeting
Budgeting Decisions
Decisions
14 - 73
The Impact of Inflation
Even small rates of inflation over time can have considerable
effects on the economic viability of a project.
Although inflation is often measured by aggregate changes
in prices at the retail (CPI consumer price index) or
wholesale level, these measures often do not reflect price
changes specific to one company or one project.
Inflation MUST be treated consistently in our project
evaluation models (NPV, IRR, PI)
Decisions
14 - 74
Two Basic Approaches
Inflation can be consistently incorporated by:

1. Removing it from the nominal discount rate and
using nominal cash flow forecasts
2. Leaving the discount rate with an expected inflation
component and estimating real (inflation-adjusted)
cash flows
Decisions
14 - 75
Removing Expected Inflation from the Discount Rate
As illustrated on the following slide, all discount rates used
have embedded into them, an expected rate of inflation.
If we use non-inflation adjusted cash flow forecasts, and
then discount using a nominal discount rate, we are over
discounting because we are using a higher ratebut not
using inflated forecast cash flows.
You can use the Fisher equation to estimate the embedded
inflationary expectations, and then reduce the nominal
discount rate by that amount.
Then you are free to discount nominal cash flows.
Decisions
14 - 76
Risk Adjusted Discount Rates
Using the CAPM
Market
= 1
Required
Return
RF

M
ER
M

Proj ect Proj ect
) ( | RF ER RF k
M
+ =
Project
=
1.5
ER
Project

Risk Premium
for project
systematic risk
Real rate of return
Premium for expected inflation
Decisions
14 - 77
Required Rates of Return (RADR)
Components

The risk-free rate is
equal to the real rate of
return plus expected
inflation (Fisher
Equation)
The risk premium is
based on an estimate of
the risk associated with
the project.
Premium Risk RF+ = RADR
Beta of the
Project
Required
Return (%)
RF
Risk
Risk Adjusted
Discount
Rate
Risk
Premium
Real Return
Expected Inflation Rate
Decisions
14 - 78
The Inflation Adjustment Process
The key thing to remember is:

If you use WACC unadjusted, then you must use
inflation-adjusted cash flow estimates for operating
cash flows
If you remove inflation from the discount rate
(WACC), you can use nominal cash flow estimates.

The key is consistency!
Decisions
14 - 79
Summary and Conclusions
In this chapter you have learned:
Several approaches and guidelines for estimating future
cash flows associated with an investment
The equations used to estimate the present value of
future cash flows
How to differentiate between expansion and replacement
decisions
How to use sensitivity analysis, scenario analysis, what-if
decision tree analysis and NPV break-even analysis.
How to incorporate inflation into capital budgeting analysis.
Concept Review Questions
Budgeting Decisions

Decisions
14 - 81
Concept Review Question 1
Treatment of Taxes and Inflation
How should we treat taxes and inflation when
determining the present value of future cash flows?

Company A

An Example of NPV Decomposition, Capital Cost Allowance and
Taxation Issues on Ending Cash Flows (ECF
n
)
APPENDIX 1
Decisions
14 - 83
Company A
The Given Information
Company A Limited is considering an investment with an initial cost of
$200,000 that will yield the following incremental before-tax and depreciation
operating cash flows benefits of:

Year Cash flows
1 $50,000
2 $60,000
3 $70,000
4 $80,000
5 $100,000

The firm will sell this depreciable asset at the beginning of year six for $20,000
and this asset is the only one in the undepreciated capital cost pool. The UCC
of the pool at the time of asset acquisition is $0.00. The company faces a tax
rate of 45%, its cost of capital is 12%, and the capital cost allowance rate for
this pool is 20%.

Calculate the project's NPV.
Decisions
14 - 84
Company A
Issues Arising from the Given Information
Uneven Operating Cash Flows
When the cash flow benefits are not equal over time they must
be discounted separately.

Terminal Loss Possibility
Whenever you sell the last asset in an asset class there is the
possibility of a terminal loss benefit to the firm.

Need to Forecast Ending UCC
You need to forecast ending UCC of the pool so that it can be
compared to the forecast salvage value to determine whether a
recapture or terminal loss is to occur.

Decisions
14 - 85
Company A
Timing of Asset Disposal
Management usually has some control over the timing of the sale of an asset.
It does NOT make sense to sell the asset immediately BEFORE the firms
fiscal year end (ie. t = 5 )
Management would wait until the first day of t = 6 and then sell the asset so
that they can receive the tax shield benefit of the last year of CCA.
For analysis purposes, then we still would use t = 5, not t = 6, because the
first day of the 6
th
fiscal year is very close to the end of year 5.

Timing of Terminal Loss Benefit
The asset may be sold at the beginning of the 5
th
year, but the company wont
file its income tax return until the end of the year. It is at that time the
company would realize its tax shield benefit from the terminal loss.
This fact affects the discount rate we use to find the present value of the
Terminal Loss Tax Shield Benefit.

Decisions
14 - 86
Company A
Present Value of Tax Savings on CCA Spreadsheet Approach
Capital Cost Allowance Schedule
CCA rate = 20.0%
Tax Savings PVIF @ Present Value
Year UCC CCA on CCA 12.0% Tax Savings
1 $200,000 $20,000 $9,000 0.892857 $8,036
2 180,000 36,000 16,200 0.797194 12,915
3 144,000 28,800 12,960 0.71178 9,225
4 115,200 23,040 10,368 0.635518 6,589
5 92,160 18,432 8,294 0.567427 4,706
6 73,728 PV of Tax Savings on CCA = $41,470
Terminal loss = $53,728
UCC
6
is the
forecast
undepreciated
capital cost at
the beginning
of the 6
th
year
when the asset
is likely to be
sold.
The estimated salvage value (SV) is only $20,000. When
subtracted from the $73,728 UCC of the pool, this leaves
$53,728 to be a non-cash deduction (written off for tax
purposes.) The after-tax benefit the company will receive
= terminal loss T .
The sum of the present value of
the tax savings on CCA (T
CCA
t
) = $41,470.
Later slides will confirm this
value by way of formula.
Decisions
14 - 87
Company A
Finding Ending UCC
You can always do a detailed table to finding ending UCC given
the assumption of maximum use of available CCA in each
year
However, you can also use a formula:

728 , 73 $
) 4096 )(. 9 (. 000 , 200 $
) 8 )(. 9 (. 000 , 200 $
) 2 . 1 )(
2
2 .
1 ( 000 , 200 $
) 1 )(
2
1 (
5
5
4
5
1 5
5
1
0
=
=
=
=
=
UCC
UCC
UCC
UCC
d
d
C UCC
n
n
Decisions
14 - 88
Company A
Present Value of Tax Savings on CCA Formula Approach
When you dispose of the last asset, (you subtract the salvage value
from the UCC of the pool at the time of sale) if a balance remains in the
pool, this is called a terminal loss and can be used as a non-cash
deduction.
When calculating the PV of Tax Savings on CCA you must modify the
formula for this fact (the fact that the UCC of the pool will be reduced to
zero because of the terminal loss)
Please confirm that the formula results in the same answer found in the
spreadsheet approach:
| | | |
$41,470
61 . 765 , 11 $ 58 . 236 , 53 $
5674 . 0 736 , 20 $ 946428 .
.32
$18,000

) 12 . 1 (
1
.32
)(.45) $73,728(.2
-
12 . 1
06 . 1
.12 .2
(.2)(.45) ($200,000)

) 1 (
1
) (
) )( )( (
) 1 (
) 5 . 0 1 ( ) )( )( (
) (
5
0
=
=

(
+
=
+
+
+
+
=
n
n
k k d
T d UCC
k
k
k d
T d C
Shield Tax CCA PV
Decisions
14 - 89
Company A
Present Value of Tax Savings on CCA Formula Approach
When you dispose of the last asset, (you subtract the salvage value
from the UCC of the pool at the time of sale) if a balance remains in the
pool, this is called a terminal loss and can be used as a non-cash
deduction.
When calculating the PV of Tax Savings on CCA you must modify the
formula for this fact (the fact that the UCC of the pool will be reduced to
zero because of the terminal loss)
Please confirm that the formula results in the same answer found in the
spreadsheet approach:
| |
58 . 236 , 53 $
946428 .
.32
$18,000

12 . 1
06 . 1
.12 .2
(.2)(.45) ($200,000)

) 1 (
) 5 . 0 1 ( ) )( )( (
) (
0
=
=
(
+
=
+
+
+
=
k
k
k d
T d C
Shield Tax CCA PV
Decisions
14 - 90
Company A
Spreadsheet Solution
Company A
Corporate Tax Rate = 45.0%
CCA rate = 20.0%
PVIF @ Present
Year Type of Cash Flow BTCF ATCF 12.0% Value
0 Initial Cost -$200,000 1 -$200,000
1 Operating Cash Flow Benefits $50,000 27,500 0.892857 24,554
2 60,000 33,000 0.797194 26,307
3 70,000 38,500 0.71178 27,404
4 80,000 44,000 0.635518 27,963
5 100,000 55,000 0.567427 31,208
1-infinity Present Value of Tax Shield on CCA 53,237 41,470
5 Present Value of Tax Savings lost on disposal of asset -20,736 0.567427 -11,766
5 Salvage Value of the Asset 20,000 0.567427 11,349
6 Terminal Loss Benefit 24,178 0.506631 12,249
NPV = $2,504
| |
58 . 236 , 53 $
946428 .
.32
$18,000

12 . 1
06 . 1
.12 .2
(.2)(.45) ($200,000)

) 1 (
) 5 . 0 1 ( ) )( )( (
) infinity through 1 years Shield Tax CCA (
0
=
=
(
+
=
+
+
+
=
k
k
k d
T d C
PV
| |
61 . 765 , 11 $
5674 . 0 736 , 20 $
) 12 . 1 (
1
.32
)(.45) $73,728(.2

) 1 (
1
) (
) )( )( (
UCC use we so off written is class asset whole the :
) infinity through 6 years sale asset of because lost Shield Tax CCA (
5
pool
=
=
=
+
+
=
n
n
k k d
T d UCC
NOTE
PV
There are no tax implications for the
salvage value because the asset is sold
for a price less than its original cost (ie.
No capital gain) and less than the UCC
pool

(ie. No recapture of depreciation).
Decisions
14 - 91
Company A
Summary
In this example you learned:

How to set up a spreadsheet model to solve for a decomposed
Net Present Value.
How to discount an uneven stream of operating cash flow
benefits before tax.
How to identify a terminal loss and how the terminal loss will
result in a tax shield benefit as part of the ECF
n

How to calculate the present value of tax savings on a finite
stream of CCA deductions.
How a terminal loss results in a complete write off the UCC in a
pool.

BACKUS DISTRIBUTING LIMITED

An Comprehensive Example of NPV Decomposition involving
Acquisition of Multiple Assets for a Project together with CCA,
Identification of relevant costs, Net Working Capital Investment and
Taxation Issues on Ending Cash Flows (ECF
n
) Inflation
Adjustment is Required in a Risk-Adjusted Discount Rate Setting
APPENDIX 2
Decisions
14 - 93
Backus Distributing Limited
The Given Information
Backus Distributing Limited is considering an investment project that involves
the establishment of a new regional distribution warehouse in Saskatoon to
serve western Canada. The firm holds land in that city. This land was
purchased for $250,000 five years ago for a new retail outlet, but because of
economic factors and poor location that project never started. Today, the firm
could sell the land for $800,000.

The warehouse project would also require construction of a building and
installation of equipment for $300,000 and $120,000 respectively. The firm
expects that once the project is up and running, it will have to maintain a
greater investment in accounts receivable and inventories that will average
$75,000 throughout the projects life.

This project is riskier than the firm as a whole and management prefers to use
risk-adjusted discount rates when considering such projects.

Other data pertaining to this project is summarized in the table on the
following slide:

Calculate the project's NPV.
Decisions
14 - 94
The Warehouse Project Information
Land Building Equipment
Net Working
Capital
Acquisition/Asset Data:
Initial Cost to be determined $300,000 $120,000 $75,000
CCA Class n/a 1 8 n/a
CCA Rate (d) 4.0% 20.0%
UCC
beginning
(before acquisition) n/a $3,533,230 $40,000 n/a
Number of assets in asset class 0 5 12 n/a
Estimated salvage value (SV) at the end of the useful life $1,200,000 $200,000 $100,000
Operating Cash Flow Data:
Annual net operating cash flow benefits before-tax = $850,000
Useful life of the project (years) = 10
Beta Coefficient for the project = 1.85
Overall Corporate Data:
Corporate Tax Rate (T) = 40.0%
Market Data:
Real rate of return demanded by investors = 2.6%
Current yield on 91-day Government of Canada Treasury Bills = 4.6%
Market premium for risk = 4.0%
Decisions
14 - 95
Equal Annual Operating Cash Flows
Use an annuity formula to quickly determine the present value of the
after-tax cash flows (BTCF (1 T))

Treatment of Land
Land is not a depreciable asset for tax purposes.
Land often is expected to appreciate in value and can lead to capital
gains on disposal.

Initial Cost of the Land
An appropriate cost for the land is part of the initial cash flow for the
project (CF
0
).
The original cost of the land of $250,000 is a sunk cost and is
therefore not relevant.
The fact that the land can now be sold for $800,000 is an opportunity
cost (OC) and is relevant to this decision.

Decisions
14 - 96
Risk-Adjusted Discount Rate
The CAPM formula to determine investors required
rate of return given the risk-free rate (RF), the
market premium for risk and the project beta.

Inflation Adjustment
Operating cash flows are expressed in nominal
terms
It is necessary to remove the expected rate of
inflation from the RADR.

Decisions
14 - 97

Ending Cash Flow Issues
Recapture of depreciation might be expected in the case of the
equipment given the low balance in beginning UCC of the pool,
and the high CCA rate, and the 10 year life of the project.
No terminal losses should be expected because each
depreciable asset class has numerous other assets in the
class.
Recapture is unlikely in the building asset class because of the
high starting balance and the low rate of CCA.
Capital gains on sale of land will be the difference between
selling price and original cost (not selling price less opportunity
cost)

Decisions
14 - 98
Treatment of Net Working Capital Investment
Working capital is not a depreciable investment.
The cost of the working capital investment is an
initial cash flow (CF
0
) that will be recovered in
nominal terms at t = n = 10 years.
Risk Assessment
How strong is the NPV?
Looking at the decomposed costs and benefits for
this project, which factors are most critical in
ensuring a positive NPV?
As a manager how would you monitor / manage
these factors?

Decisions
14 - 99
The Backus Distributing Limited
Challenge
This project is an excellent example of the
application of the principles covered in Chapter 14.
Use this as a challenge exercise or hand-in
assignment problem.
The following slides gives you a structure to start
with in solving this problem.
Decisions
14 - 100
Estimating the Required Return on the
Warehouse Project
Using the CAPM, the required rate of return on a project I is a
function of the risk-free rate of return (RF) and market premium for
risk (ER
M
RF) and the systematic risk of the project (Beta
Coefficient)
We use equation 9 to solve for k
i
:

Because the projects risk significantly different from that of the firm
as a whole (much greater) we will use the RADR rather than WACC.
% 0 . 12
% 4 . 7 % 6 . 4
85 . 1 %) 4 ( % 6 . 4
) (
=
+ =
+ =
+ =
i
i
i
i M i
k
k
k
RF ER RF k |
[9-9]
Decisions
14 - 101
Determining the Expected Rate of
Inflation
The Fisher Equation from Chapter 6 allows us to estimate the
expected inflation premium that is incorporated in the risk-free rate
of return (Yield on 91-day Treasury Bills)
The market information we have been given is that
the RF (yield on 91-day T-bills) is 4.6%
Real rate of return demanded by investors is 2.5%
The implicit rate of inflation embedded in these relationships is:

2.0% 2.6% - 4.6% inflation Expected
inflation Expected 2.6% 4.6%
inflation Expected rate Real RF
= =
+ =
+ =
[ 6-5]
Decisions
14 - 102
Adjusting the Required Return for
Expected Inflation
With expected inflation at 2.0% and RADR = 12%
(determined in the previous slides) is the nominal
rate, our inflation-adjusted (relevant) discount rate
is:
10% 2% - 12%
inflation - RADR Rate Discount adjusted - Inflation
= =
=
Decisions
14 - 103
Spreadsheet Solution Initial Cash Flows (CF
0
)
Warehouse Project Proposal
Corporate Tax Rate = 40.0%
Inflation-adjusted risk-adjusted discount rate = 10.0%
CCA rate for Class 1 Asset (building) = 4.0%
CCA rate for Class 8 Asset (equipment) = 20.0%
Present
Value
Factor @ Present
Year Type of Cash Flow BTCF ATCF 10.0% Value
Initial Cash Flows (CF
0
)
0 Opportunity cost of the land -$800,000 1 -$800,000
0 Cost of Building -300,000 1 -300,000
0 Cost of Equipment -120,000 1 -120,000
0 Investment in Working Capital -75,000 1 -75,000
TOTAL CF
0
= -$1,295,000
Decisions
14 - 104
Spreadsheet Solution Operating Cash Flows (CF
n
)
Decisions
14 - 105
Spreadsheet Solution Net CCA Tax Shield Cash Flow Benefits
Decisions
14 - 106
Spreadsheet Solution Ending Cash Flows (EF
n
)
Decisions
14 - 107
Spreadsheet Solution Net Present Value
Decisions
14 - 108
Summary
In this comprehensive example you learned:

How to set up a spreadsheet model to solve for a decomposed Net
Present Value.
How to discount an annuity of operating cash flow benefits before tax.
How to identify a recapture of depreciation and how the recapture will
result in a tax liability as part of the CF
n

How to calculate the present value of tax savings on a finite stream of
CCA deductions in two different asset classes and incorporate into the
NPV framework.
How to identify relevant costs.
How to estimate a risk-adjusted discount rate.
How to incorporate inflation into an NPV analysis.
How to incorporate net working capital investment into a NPV model.
Decisions
14 - 109
Copyright
Copyright 2007 John Wiley & Sons
Canada, Ltd. All rights reserved.
Reproduction or translation of this work
beyond that permitted by Access
Copyright (the Canadian copyright
licensing agency) is unlawful. Requests
for further information should be
addressed to the Permissions
Department, John Wiley & Sons Canada,
Ltd. The purchaser may make back-up
copies for his or her own use only and
not for distribution or resale. The author
and the publisher assume no
responsibility for errors, omissions, or
damages caused by the use of these files
or programs or from the use of the
information contained herein.

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