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FNCE 2P91 (13)
Chapter 10


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Clarke Melville

FNCE 2P91 - Section 05 Winter 2011 - Duration 03 08.03.11 FNCE 2P91: Corporate Finance-Notes-Chapter 10: Capital Budgeting Notes MIDTERMS  Will be handed back next week  Average have been seen as low 50s o Will be boosting marks about 10-15%  Answers will be posted NEXT WEEK  What happens if there is a strike? o Unless you hear something back before next Tuesday class will still be going on  Slides will be posted on Sakai Capital Budgeting  Process by which firms allocate (budget) or commit funds (capital) to investment s to generate at least 1 year into the future o Contrast to working capital management that typically deals with short term (<1 year) assets The Capital Budgeting Process 1. Generate Ideas 2. Analysis of Proposals a. Forecast cash flows and evaluate project profitability 3. Planning the Capital Budget a. Strategic Fit, Timing 4. Monitor and Post-auditing a. Did the project deliver… Rough Categories for Analysis 1. Buy or replace 2. Expansion projects a. Increase existing business 3. New products or Services a. More uncertainty than expansion projects 4. Regulatory, safety and environmental Basic Principles of Capital Budgeting  Decisions are bases on Cash Flows o Not on accounting concepts (e.g. Net Income)  Timing of Cash Flows in crucial  Cash flows are based on opportunity costs o Independent projects vs. Mutually Exclusive  Cash Flows are analyzed on an after tax basis  Financing costs are ignored o Objective of capital budgeting is to determine if projects are viable under required rates of return o Financing costs are inherent in required return You actually use this stuff at work  This section will focus on the techniques to quantify the attractiveness….  We are getting ready to run a more comprehensive capital budgeting analysis FNCE 2P91 - Section 05 Winter 2011 - Duration 03 Identification of Relevant Cash Flows in Capital Budgeting Analysis ITEM INCLUDE? Sunk Costs Not relevant to decision at hand, do not include Opportunity Costs Need to include – E.g. use if land that could be sold Cannibalization or Erosion Costs Need to include – E.g. launch of a new soft drink by Coke will decrease Changes in Net Working Capital (NWC) Financing Costs Taxes Intangibles Treatment of Capital Spending  Matching principle in accounting means that large capital expenses are expensed over time o Match of revenues and expenses  Example: o Real Estate developer builds a new $80 million apartment – assume that it takes 1 years to build:  Generally Accepted Accounting Principles (GAAP) could have company depreciate the $80 million expense over the life of the project – e.g. 20 years or $4 million per year  The relevant cash flows from a Finance perspective are different than Accounting o Year 1 cash outflow of $80 million… Capital Cost Allowance CCA  CCA is deprecation for tax purposes  CCA is deducted before taxes and acts as a tax shield  Every capital asset is assigned a specific asset class by the government  Every asset class is given a depreciation method rate  Half- year… Example: CCA Calculation ABC Corporation purchased $100 000 worth of photocopiers in 2007. Photo… CCA Example – Solution PV of CCA Tax Shield Formula Where: C = Cost of Asset D = CCA tax rate TC= Corporate Tax Rate k = discount rate S = Salvage value n = number of periods in the project 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… FNCE 2P91 - Section 05 Winter 2011 - Duration 03 CCA Question: An asset purchased of $450 000 and an installation cost of $120 000. CCA rate is 30% and the Corporate Tax Rate is 40%. Assume that eh asset purchased is going to generate revenues of $200 000 per year. What is the ending UCC (Unappreciated Capital Cost) in year three? Answer: Beginning UCC CCA Ending UCC Year 1 199 500 Year 2 484 500 145 350 339 150 Year 3 339 150 101 745 237 405 *CCA is not a cash item. But it reduces taxes payable Part Two: What is the Cash Flow savings in Year 2 because of the CCA expense? Answer: Revenues $200 000 $200 000 CCA Expense $145 350 $0.00___ Taxable Income $54 650 $200 000 Taxes at 40% ($21 860) ($80 000) Net Income $32 790 $120 000 – Difference or Delta (∆) 178 140 120 000 ↑ of 58 140 PV CCATS Question: Purchase of a $1 million item that will cost $50 000 to install. It has got a CCA rate of 20% and tax rate of 40%. Required return of 12%. The life of the item is 10 years and salvage for 20% of the purchase price. What is the Present Value of the tax shields savings from the capital purchase? Answer: *( )( )+ *( ) + 0 S FNCE 2P91 - Section 05 Winter 2011 - Duration 03 NET WORKING CAPITAL Inventory ↑ Cash Flows ↓ Accounts Receivable ↑ Cash Flow ↓ Accounts Payable ↑ Cash Flow ↑ Example: Net Working Capital A company has the following NWC balance
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