Financial Management

Lecture 7

Dr. Harshit Rajaiya

Telfer School of Management
University of Ottawa
 Readings
• Readings: Chapter 10

2
 Key Concepts and Skills
➢ Understand how to determine the relevant cash flows for a proposed
project
➢ Know how to project the cash flows and determine if a project is
acceptable
➢ Understand the various methods for computing operating cash flow
➢ Be able to compute the CCA tax shield
➢ Know how to evaluate cost-cutting proposals
➢ Be able to analyze replacement decisions
➢ Understand how to evaluate the equivalent annual cost of a project

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 Corporate Valuation, Cash Flows, and
Risk Analysis

Project Project Project

Firm Project Market
Sales Operating Required
Financing Risk Risk
Revenues Costs Investment

Project Free Cash Flows Project Cost of Capital

(FCF) (k or WACC)

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 Relevant Cash Flows
➢ The cash flows that should be included in a capital
budgeting analysis are those that will only occur (or not
occur) if the project is accepted.

➢ These cash flows are called incremental cash flows

➢ The stand-alone principle allows us to analyze each

project in isolation from the firm simply, by focusing on
incremental cash flows

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 Asking the Right Question
➢ You should always ask yourself: “will this cash flow
occur ONLY if we accept the project?”

• If the answer is “yes”, it should be included in the analysis

because it is incremental
• If the answer is “no”, it should not be included in the analysis
because it will occur anyway
• If the answer is “part of it”, then we should include the part that
occurs because of the project

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 Common Types of Cash Flows

Are these cash flows relevant?

• Sunk costs – costs that have been incurred in the past
• Opportunity costs – costs of lost options
• Side effects
– Positive side effects – benefits to other projects
– Negative side effects – costs to other projects
• Changes in net working capital
• Interest expenses
• Inflation
• Capital Cost Allowance (CCA)

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 Initial Investment (Initial Cash Flows
CF0)
Initial investment may include:
➢ Cost of equipment (e.g., the price you pay for the machinery)
➢ Related costs
• Shipping cost, set-up costs, installation costs etc.
➢ Opportunity costs
• Cash flow forgone as a result of the investment
➢ Changes in Net Working Capital (NWC)
• NWC = Current Assets – Current Liabilities
• Firms need to keep certain amount of cash to be able to eliminate the
liquidity mismatch
• You usually get NWC back at the end of project
• Sometimes also investments during life of the project

Do not include sunk costs (costs already spent and that cannot be
recovered: “And it’s gone!!!”)
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Estimate Operating Cash Flows (OCF)

Equivalent Definitions of Operating Cash Flows

1. Bottom-Up Approach:

• 𝑂𝐶𝐹 = 𝑁𝑒𝑡 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑃𝑟𝑜𝑓𝑖𝑡 𝐴𝑓𝑡𝑒𝑟 𝑇𝑎𝑥𝑒𝑠 (𝑁𝑂𝑃𝐴𝑇) + 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛

2. Top-Down Approach:

• 𝑂𝐶𝐹 = 𝑆𝑎𝑙𝑒𝑠 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 − 𝐶𝑜𝑠𝑡𝑠 − 𝑇𝑎𝑥𝑒𝑠

3. Tax Shield Approach:

• 𝑂𝐶𝐹 = 𝑆𝑎𝑙𝑒𝑠 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 − 𝐶𝑜𝑠𝑡𝑠 ∗ 1 − T + [Depreciation ∗ T]

Depreciation tax shield or

CCA Tax Shield
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Other Considerations in Estimating Cash
Flows
• Side Effects: Erosion vs. Synergy
• Allocated Costs
• Interest Costs (count in the WACC not in the OCF)
• Adjusting for Inflation

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 Side Effects
• Side effects matter
– Erosion / cannibalism
▪ e.g., Apple introduces the iPad and MacBook
sales decline
▪ Be Careful! In the 1970s IBM passed on the PC
due to fear of it cannibalizing its mainframe
business and almost went bankrupt as a result.

– Synergies
▪ e.g., Apple introduce the iPhone and iTunes sales
increase

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Allocated Costs
➢ Sometimes the asset you bought for a project is used for
different projects.

➢ Should be accounted for in cash flows if:

• Create an additional incremental cost.
• e.g., employees working on an old project, stay late to work
and incur overtime pay to work on the new project.

➢ Should not be accounted for in cash flows if:

• Allocations of overhead costs should not affect a project's
incremental cash flows unless the project actually
increases overhead expenses
• e.g., overhead costs, such as heat and lights, incurred
whether the project investment is made or not.

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 Inflation
➢ Rule: Be consistent!
• Discount nominal cash flows using nominal interest rate (be
careful about depreciation, it is a nominal cash flow).
• Discount real cash flows using real interest rate.

The (Irving) Fisher Equation:

𝟏 + 𝑵𝒐𝒎𝒊𝒏𝒂𝒍 𝑹𝒂𝒕𝒆 = 1 + 𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 ∗ (1 + 𝑹𝒆𝒂𝒍 𝑰𝒏𝒕. 𝑹𝒂𝒕𝒆)

• Approximation:
𝑵𝒐𝒎𝒊𝒏𝒂𝒍 𝑰𝒏𝒕. 𝑹𝒂𝒕𝒆 − 𝑰𝒏𝒇𝒍𝒂𝒕𝒊𝒐𝒏 = 𝑹𝒆𝒂𝒍 𝑰𝒏𝒕. 𝑹𝒂𝒕𝒆

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 Interest Expense
➢ Many projects are financed at least partially with debt. Do we
consider interest expense in our incremental cash flows?

➢ The discount rate used in discounting project cash flows is the

weighted average cost of capital (WACC), representing the rate of
return for all investors, both shareholders and debtholders.

➢ Be consistent: the project cash flows to be discounted should also be

those available to all investors.

➢ Therefore, interest expenses – cash flows to debtholders – should

NOT be subtracted

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 Taxes and Depreciation
◼ Depreciation is not a cash flow item but indirectly impacts
cash flows through (lower) taxes.

◼ Income Tax Act (in Canada): Capital Cost Allowance (CCA)

is the depreciation for tax purposes
o Asset classes
o Undepreciated capital cost (UCC): the remaining balance of the
asset that still needs to be depreciated
o 50% rule
• In the first year you calculate depreciation based only 50% of the
value of the asset
• In the second year you calculate depreciate against the full value
of the asset (minus the amount you depreciate in the first year)

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 Capital Cost Allowance (CCA)
➢ CCA is depreciation for tax purposes.

➢ The depreciation expense used for capital budgeting

should be calculated according to the CCA schedule
dictated by the tax code.

➢ Depreciation itself is a non-cash expense, consequently, it

is only relevant because it affects taxes.

➢ Depreciation tax shield = D x T

o D = depreciation expense
o T = marginal tax rate

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 Computing Depreciation
➢ Need to know which asset class is appropriate for tax
purposes.

➢ Straight-line depreciation
• D = (Initial cost – salvage) / number of years

➢ Declining Balance
• Multiply percentage given in CCA table by the un-depreciated
capital cost (UCC)
• Half-year rule
• Can use PV of CCA Tax Shield Formula

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 Capital Cost Allowance: Asset Classes

Note that larger CCA rates reduce taxes and increase cash flows as the
CCA is deducted in computing taxable income
You do not need to memorize these rates, they will be given in a problem.

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 Depreciation & Tax Shields
➢ Different classes of assets depreciate at different rates.

➢ E.g., Class 1 assets - industrial buildings, depreciate at 4% per year.

▪ Purchase a building for $10M. The CCA and Undepreciated Capital Cost (UCC) are:
Year 1: $10𝑀 ∗ 50% ∗ 0.04 = $0.2𝑀; UCC = $10M-$0.2M = $9.8M
Year 2: $9.8𝑀 ∗ 0.04 = $0.392M; UCC = $9.8M – $0.392M = $9.408M
Year 3: ? UCC =?

➢ We will also use straight line depreciation: Dep.=(initial value – salvage value)/number of years. Salvage
value (S) = value of the asset at the end of its accounting life. Usually, S=0.

• Purchase a building for $10M. Assuming it will last 25 years. The Straight-line
depreciation is:

Year 1: $10𝑀/25 = $400𝐾

Year 2: $10𝑀/25 = $400𝐾

𝑂𝐶𝐹 = 𝑆𝑎𝑙𝑒𝑠 − 𝐶𝑜𝑠𝑡𝑠 ∗ 1 − T + [Depreciation ∗ T]

Put CCA or straight line dep. here 19

 Simplification for PV CCA Tax Shield
◼ Tax shields from CCA continue in perpetuity as long as there
are assets in the asset class.
▪ Ignoring the fact that only half of the cost can initially be contributed
to the asset class, what is the PV of the tax shields generated from
the CCA?

𝐶𝐹1
𝑃𝑉 =
𝑘−𝑔
Where CF1 is the cash flow at year 1 (the depreciation tax shield)
k is discount rate
g is the cash flow growth rate

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 Tax Shield Over Time
Let the Asset Cost be $100K, the CCA Rate be 10%, and the Marginal Tax
Rate is 40%

But there is the 50% rule, and the cash flow is decreasing
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 Simplification for PV CCA Tax Shield
◼ PV of a perpetuity decreasing at a rate d
T = Firm’s marginal Tax Rate
d = CCA Rate
PV year one of CCA TdC0 C0 = Capital Cost of Asset
0.5
k +d k = discount rate (before was r)

TdC0  1 
0.5  
PV year two of CCA k + d 1+ k 

 TdC0  1 + 0.5k 
Total   
 k + d  1 + k 
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What if we Sell? Tax Shield Over Time
If you sell the asset at the end of the 10th year, the tax shield looks like
as follows:

The loss of tax

shield due to
asset sale

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 Last Step: Salvage Value (S)
◼ What if we sell the asset for S? We don’t get all of the CCA deductions:

◼ Loss of Tax shields:

Td ( S )
k +d
◼ If the sale occurs in year n?

Td ( S )  1 
 
n 
k + d  (1 + k ) 

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 PV of CCA Tax Shield Formula
C0 dT 1 + 0.5𝑘 𝑆𝑑𝑇 1
PV tax shield on CCA = × − ×
d+k 1+𝑘 𝑑 + 𝑘 (1 + 𝑘)𝑛

➢ Where:
• C0 = Total Capital Investment
• d = CCA tax rate
• T = Corporate Tax Rate
• k = discount rate
• S = Salvage value in year n
• n = number of periods in the project

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 Example: Depreciation and Salvage

You purchase equipment for $100,000 and it costs $10,000

to have it delivered and installed. Based on past
information, you believe that you can sell the equipment for
$17,000 when you are done with it in 6 years. The
company’s marginal tax rate is 40%. If the applicable CCA
rate is 20% and the required return on this project is 10%,
what is the present value of the CCA tax shield?

C0dT 1 + 0.5k S dT 1
PV tax shield on CCA =  − 
d+k 1+ k d + k (1 + k )n
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 Example: Depreciation and Salvage
continued
➢ The delivery and installation costs are
capitalized in the cost of the equipment
C0dT 1 + 0.5k S dT 1
PV tax shield on CCA =  − 
d+k 1+ k d + k (1 + k )n

110,000  0.20  0.40 1 + 0.5  0.10

PV tax shield on CCA = 
0.20 + 0.10 1 + 0.10

17,000  0.20  0.40 1

− 
0.20 + 0.10 (1 + 0.10) 6

= 25,441.05
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 The Complete NPV Formula
NPV = – CF0 + PV (after-tax operating income) + PV (CCA tax shields) +
PV (ending cash flows)

 TdC 0  1 + 0.5k   1   Td (S)

PV of CCA tax shields =     − n 
 k + d  1 + k   (1 + k )   k + d 
T = Firm' s marginal tax rate
d = CCA rate
C0 = Capital cost of the asset
k = Opportunity cost of capital or WACC
S = Net salvage value of the project at end
n = Useful life of the project

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 NPV Example

Smith Industries Ltd. is purchasing a fleet of trucks for $105,000

and will also pay $5,000 acquisition costs. The trucks will be part of
their class 10 pool of assets that has a CCA rate of 30%.
They have a useful life of 3 years and a net resale value of $10,000
at that time. Cash inflows and outflows are $80,000 and $20,000
per year, respectively. T = 40% and k = 14%.

Should the fleet be purchased?

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 NPV Example (Solution)
(1) Initial Cash Flows (i.e. CFo) =>
Capital costs for depreciation purposes = $105,000 + $5,000 = $110,000

(2) PV (after-tax operating income) =>

PV of 3 annuity of (Rev.-Costs)(1-T) each
= (80,000-20,000)(1-.4) [(1-1/(1+14%)3)]/14%
= $36,000(2.3216) = $83,578

(3) PV (CCA Tax shields) =>

C0dT 1 + 0.5k S dT 1
PV of gain and loss in tax shields =  − 
d+k 1+ k d + k (1 + k )n
= [($110,000)(.3)(.4) /(.3+.14)] [(1.07)/(1.14)]– [($10,000) (.3)(.4)]/[(.3+.14)]1/(1.14)3
= $28,158 - $1,841 = $26,317

(4) PV (Ending cash flows) =>

(Salvage value)/(1+k)t = ($10,000/(1.14)3 = $6,750

NPV= - (1)+(2)+(3)+(4)= - $110,000 + $83,578 + $26,317 + $6,750 = $6,645

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 Example: Replacement Problem
➢ Original Machine ➢ New Machine
• Initial cost = 100,000 • Initial cost = 150,000
• CCA rate = 20% • 5-year life
• Purchased 5 years ago • Salvage in 5 years = 0
• Salvage today = • Cost savings = 50,000 per
65,000 year
• Salvage in 5 years = • CCA rate = 20%
10,000 ➢ Required return = 10%
➢ Tax rate = 40%

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 Example: Replacement Problem

➢ Remember that we are interested in incremental cash

flows
➢ If we buy the new machine, then we will sell the old
machine
➢ What are the cash flow consequences of selling the old
machine today instead of in 5 years?

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 Example: Replacement Problem

➢ If we sell the old equipment today, then we will receive

$65,000 today. However, we will also NOT receive
$10,000 in 5 years
➢ The appropriate number to use in the NPV analysis is
the net salvage value
➢ Always consider after-tax cash flows
➢ You can use your calculator for the cash flows and
salvage, but there are no short cuts for finding the PV of
the CCA tax shield

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 NPV Example (Solution)
(1) Initial Cash Flows (i.e. CFo) =>
Investment in new equipment + sale of old equipment= $-150,000 + $65,000

(2) PV (after-tax operating income) =>

PV of 5 annuity of (Savings)(1-T) each
= (50,000)(1-.4) [(1-1/(1+10%)5)]/10%

(3) PV (CCA Tax shields) =>

C0dT 1 + 0.5k S dT 1
PV of gain and loss in tax shields =  − 
d+k 1+ k d + k (1 + k )n
150,000×0.2×0.4 1+0.5×0.1
= New equipment: ×
0.10+0.20 1.10
(4) Opportunity Costs
10,000
Opportunity Cost of the Salvage value of old equipment: -
1.105

Opportunity cost of the loss of Tax shield from the old equipment

-( 65,000×0.2×0.4
0.10+0.20
×
1+0.5×0.1
1.10
−
10,000×0.2×0.4
0.10+0.20
1
x 1.105 )
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 Example: Replacement Problem

 1 
1 −
 1.15  10,000
NPV = −150,000 + 65,000 + 50,000(1 − 0.4)  − 5
 0 .10  1.10
 

65,000  0.2  0.4 1 + 0.5  0.1 10,000  0.2  0.4 1

−  + 
0.10 + 0.20 1.10 0.10 + 0.20 1.105

150,000  0.2  0.4 1 + 0.5  0.1

+ 
0.10 + 0.20 1.10

NPV = 45,806.54

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 Example: Cost Cutting
• Your company is considering a new production system that will initially
cost $1 million. It will save $300,000 a year in inventory and receivables
management costs. The system is expected to last for five years and will
be depreciated at a CCA rate of 20%. The system is expected to have a
salvage value of $50,000 at the end of year 5. There is no impact on net
working capital. The marginal tax rate is 40%. The required return is 8%.

• Click on the Excel icon to work through the example

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 Example: Cost Cutting
Initial Cost of New Equipment 1,000,000
Expected Salvage of New Equipment 50,000
After-tax Savings 180,000=300,000*(1-0.4)
Tax Rate 40%
CCA Rate 20%
Discount Rate 8%
Number of periods 5

Year 1 2 3 4 5
After-tax Savings 180,000 180,000 180,000 180,000 180,000

Initial Cost -1,000,000

PV of After-tax Savings 718,688
PV of Salvage on New Machine 34,029
PV of CCA Tax Shield 265,410

Net Present Value 18,127

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Example: Evaluating Projects of Unequal
Lives
▪ There are times when application of the NPV rule can lead to the
wrong decision.

▪ Equivalent Annual Cost/Benefit: Establish the cost/benefit of the two

projects on an annual basis.

▪ The Equivalent Annual Cost (EAC) is the value of the level payment
annuity that has the same PV as our original set of cash flows.

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 Example: Evaluating Projects of Unequal
Lives
➢ A company is considering two mutually exclusive pieces of machinery.
➢ Machine A costs $40,000, lasts 6 years, and generates yearly cost
savings of:
$8,000; $14,000; $13,000; $12,000; $11,000; $10,000
➢ Machine B costs $20,000, lasts 3 years, and generates yearly cost
savings of $7,000,13,000,12,000
➢ WACC = 11.5%
➢ NPV of A is $7,165, and for B is $5,391
➢ But Machine B lasts half as long!

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 Example: Evaluating Projects of Unequal
Lives

• Equivalent Annual Benefit

• Machine A:
• $7,165 = EAC [(1-1/(1+11.5%)6)]/11.5%
= EAC x 4.17
Now solving for EAC get EAC = $1,718
– Machine B:
• $5,391 = EAC [(1-1/(1+11.5%)3)]/11.5%, , solving for EAC get EAC =
$2,225

Conclusion: Buy machine B because expected annual benefit of B is higher than

that of A.

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 Summary
➢ You should know:
• How to determine the relevant incremental cash flows
that should be considered in capital budgeting
decisions
• How to calculate the CCA tax shield for a given
investment
• How to perform a capital budgeting analysis for:
• Cost cutting problems
• Replacement problems
• Projects of different lives

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