Copyright © 2003 Pearson Education Canada Inc. Slide 22-214 Chapter 22 Capital Budgeting: A Closer Look

Copyright © 2003 Pearson Education Canada Inc. Slide 22-1

Chapter 22

Capital Budgeting: A Closer Look


Income Taxes and Capital Budgeting

• Income taxes are cash disbursements which impact on cash flows

• Always consider the marginal tax rate or the rate paid on any additional amounts of pretax income

• Consider operating cash flows on a after-tax basis:

After-tax savings = $6,000 x (1 - tax rate of 40%) = $3,600

Page 810

With $6,000Current Saving Difference

Revenues $100,000 $100,000 $0Expenses 70,000 64,000 6,000

Net income before tax 30,000 36,000 6,000

tax (40%) 12,000 9,600 2,400

Net income after tax $28,000 $24,400 $3,600


Capital Cost Allowance

• Federal Income Tax Act (ITA) does not permit a company to deduct amortization (depreciation) in determining taxable income

• ITA does allow companies to deduct capital cost allowance (CCA) which is similar to amortization

• ITA assigns assets to specific CCA classes

• Undepreciated Capital Cost (UCC) correspond to Net Book Value in accounting terms

• ITA limits the rate of CCA to be half of the regular rate in the first year for most assets (half-year rule)

Pages 811 - 812


Capital Cost Allowance (CCA) Classes

Class 1 4% Buildings acquired after 1987

Class 8 20% Capital property, machinery andequipment not included in otherclasses

Class 10 30% Automotive equipment, electronicdata processing equipment

Class 12 100% Software, tools costing less than $200

Class 39 Manufacturing and processingequipment acquired after 1987 (40%, 35%, 30%, 25%)

Page 830


CCA Calculations

• CCA is similar to declining balance amortization • Cash saving on taxes (tax shield) due to the

deductibility of CCA = CCA x tax rate %

Present value d 2 + k of tax savings d + k2 ( 1 + k)

Where: C = investment, t = tax rate, d = CCA rate, k = required rate of return

Present value of tax savings

= $2,548

=

Pages 811 - 812

=

$10,000 x 40%20%

20% + 10%

2 + 10%

2 (1 + 10%)

x xC x t

x x


CCA Table

Beginning Additions Net CCA CCA EndingYear Balance Disposal Balance Rate Amount Balance

1 $0 $10,000$10,00010%$1,000 $9,0002 9,000 9,000 20% 1,800 7,2003 7,200 7,200 20% 1,440 5,7604 5,760 5,760 20% 1,152 4,6085 4,608 4,608 20% 922 3,6866 3,686 3,686 20% 737 2,9497 2,949 2,949 20% 590 2,3598 2,359 2,359 20% 472 1,8879 1,887 1,887 20% 377 1,51010 1,510 1,510 20% 302 1,20811 1,208 1,208 20% 242 96612 966 966 20% 193 773

Pages 811 - 812


Trade-ins and Disposal of Capital Assets

• CCA system works on a pool basis• If buy a new asset for $12,000 with a $4,000 trade-in,

add $8,000 to the pool• Undepreciated capital cost (UCC) is the balance of

CCA remaining on the books at any point in time • UCC is equivalent to “net book value” in financial

accounting• Ignore the UCC balance in the pool for the capital

asset that was traded in• Note that the half-year rule does not apply to CCA

calculations when capital assets are sold

Pages 813 - 814


Capital Budgeting and Inflation

• Inflation is the decline in the general purchasing power of the monetary unit

• Normal, expected inflation is included in the nominal (or normal) required rate of return

• Include inflation in capital budgeting model if significant over the life of the project

• Nominal Approach: predict cash inflows and outflows in nominal monetary units and use a nominal rate as the required rate of return

• Real Approach: predict cash inflows and outflows in real monetary units and use a real rate as the required rate of return

Pages 820 - 823


Project Risk and Required Rate of Return

• Organizations typically use at least one of the following approaches in dealing with project risk

1. Varying the required payback time (higher the risk, the shorter the desired payback time)

2. Adjusting the required rate of return (use a higher required rate for risky projects)

3. Adjusting the estimated future cash inflows (reduce cash flows for riskier projects)

4. Sensitivity (what-if) analysis

5. Probability distributions (to account for uncertainty)

Pages 824 - 825

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Copyright © 2003 Pearson Education Canada Inc. Slide 22-214 Chapter 22 Capital Budgeting: A Closer Look