# Chapter 22 Capital Budgeting: A Closer Look Copyright

Chapter 22 Capital Budgeting: A Closer Look Copyright 2003 Pearson Education Canada Inc. Slide 22-1 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 With \$6,000 Current Revenues Expenses Net income before tax tax (40%) Net income after tax Copyright 2003 Pearson Education Canada Inc. SavingDifference \$100,000\$100,000 \$0 70,00064,000 6,000 30,00036,000 6,000 12,000 9,600 2,400

\$28,000\$24,400\$3,600 Page 810 Slide 22-2 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) Copyright 2003 Pearson Education Canada Inc. Pages 811 - 812 Slide 22-3 Capital Cost Allowance (CCA) Classes Class 1 4%

Buildings acquired after 1987 Class 8 20% Capital property, machinery and equipment not included in other classes Class 10 30% Automotive equipment, electronic data processing equipment Class 12 100% Software, tools costing less than \$200 Class 39 Manufacturing and processing equipment acquired after 1987 (40%, 35%, 30%, 25%) Copyright 2003 Pearson Education Canada Inc.

Page 830 Slide 22-4 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 of tax savings = Cxt x d d+k x 2 +k 2 ( 1 + k) Where: C = investment, t = tax rate, d = CCA rate, k = required rate of return

Present value of tax savings = \$10,000 x 40% x 20% 20% + 10% x 2 + 10% 2 (1 + 10%) = \$2,548 Copyright 2003 Pearson Education Canada Inc. Pages 811 - 812 Slide 22-5 CCA Table Year 1 2 3 4 5 6

7 8 9 10 11 12 Beginning Balance Additions Net Disposal Balance CCA CCA Ending Rate Amount Balance \$0\$10,000\$10,000 10%\$1,000\$9,000 9,0009,000 20% 1,8007,200 7,2007,200 20% 1,4405,760 5,7605,760 20% 1,1524,608 4,6084,608 20% 9223,686

3,6863,686 20% 7372,949 2,9492,949 20% 5902,359 2,3592,359 20% 4721,887 1,8871,887 20% 3771,510 1,5101,510 20% 3021,208 1,2081,208 20% 242966 966966 20% 193773 Copyright 2003 Pearson Education Canada Inc. Pages 811 - 812 Slide 22-6 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 Copyright 2003 Pearson Education Canada Inc. Pages 813 - 814 Slide 22-7 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 Copyright 2003 Pearson Education Canada Inc. Pages 820 - 823

Slide 22-8 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) Copyright 2003 Pearson Education Canada Inc. Pages 824 - 825 Slide 22-9

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