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Technical Note - Solved Capita Budgeting Problems.doc

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Ryerson University
FIN 300
Michael Inglis

Technical NoteSolved Capital Budgeting ProblemsGeneral PointsRemember that capital budgeting problems are based on cash flow from assets which is composed of three types of cash flows 1 capital expendituresales 2 operating cash flows and 3 changes in NWCWe will be using the CCA tax shield formula to solve all of these problems so we will write the operating cash flow asOCFSC1TDTThe first term SC1T is the after tax operating cash flow but ignoring the impact of depreciationRemember depreciation ie CCA in and of itself is not important its a non cash item however it does reduce your taxesThe second term DT is the CCA tax shield which represents the dollar reduction in your taxes in a given year due to the ability to deduct CCA before calculating your taxable incomeWe dont want to work out all of the individual CCA or tax shield numbers for each year of a project so we will use the CCA tax shield formula to find the PV of all future tax shields in one fell swoop111CdTrSdT2PVCCATSn11rdrrdrwhere capital costCdCCA rateTcorp tax ratercost of capitalSsalvage valuenlife of project If we use this formula we will not explicitly estimate the DT terms for each yearso all we have to worry about is the SC1T component of operating cash flow 1 Replacement ProblemA firm is considering the purchase of a new machine priced at 350000 to replace an older machineThe economic life of the machine is 8 years at which time the estimated salvage value is 85000The present market value of the older machine is 50000 and is expected to have a salvage value of 15000 in 8 yearsThe new machine is expected to reduce operating expenses by 50000 per yearThe firms tax rate is 40 and its cost of capital is 15Both machines belong to class 10 with a CCA rate of 30Should the firm replace its older machine
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