2-208-97 Basic Corporate Finance Professor Iwan Meier

Cash Flow, Taxes, Project Evaluation

5. 6. 7. 8. Operating cash flow Alternative approaches CCA tax shield Special cases of DCF analysis

Iwan Meier

2-208-97 Basic Corporate Finance

165

DCF: A Detailed Example

Example

The Trucksalot company is planning to expand its current fleet of delivery trucks and has hired you as a financial advisor to estimate the investment project's net present value (NPV). After days of careful analysis you have determined that the initial cost of the project would involve a capital investment of $2,000,000. The expansion would also require an additional investment in inventory of $200,000 two years from now. Subsequently, total NWC at the end of each year would be 15% of sales for that year. This additional inventory would no longer be required once the trucks are taken off the road.

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DCF: A Detailed Example (cont.)

The company's opportunity cost of capital is 7%. The additional trucks would increase Trucksalot annual sales by $2,000,000 for the next 4 years at which time the trucks will be scrapped. Additional annual expenses of $500,000 would also be incurred due to maintenance fees on the trucks. Under Canadian tax laws, trucks are typically in a 30 % depreciation class. The companys tax rate is 40%. Notation: OCF operating cash flow S sales C operating costs D depreciation Tc corporate tax rate.
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Calculate Operating Cash Flows (OCF)

Example

Lets look at Trucksalot cash flows for the first year. Recall S = $2,000,000, C = $500,000, Tc = 40%, and D = $300,000.
EBIT = S C D = 2,000,000 500,000 300,000 = $1,200,000 Taxes = EBIT Tc = 1,200,000 M 0.4 OCF = $ 480,000

= EBIT + D Taxes = 1,200,000 + 300,000 480,000 = $1,020,000

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Alternative Definitions of OCF

The Bottom-Up Approach
OCF = = = = (S C D) + D (S C D) Tc (S C D) (1 Tc) + D Net income + Depreciation (2,000,000 500,000 300,000) (1 0.4) + 300,000 = $1,020,000

The Top-Down Approach

OCF = = = = (S C D) + D (S C D) Tc (S C) (S C D) Tc (Sales Costs) Taxes (2,000,000 500,000 480,000 = $1,020,000
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Iwan Meier

Alternative Definitions of OCF (cont.)

The Tax-Shield Approach
OCF = = = = (S C D) + D (S C D) Tc (S C) ( 1 Tc) + (D Tc) (S C) (1 Tc) + Depreciation tax shield (2,000,000 500,000) (1 0.4) + 300,000 0.4 = $1,020,000

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170

Applying the Tax Shield Approach

CCA tax shield (or depreciation tax shield) is the reduction in taxes payable due to CCA. If the company has capital expenses, how can it calculate the tax implications? Things get complicated fast. We look at a very simple base case. Then we will talk about a few complications We need to know about CCAs to calculate the PV of their tax shield.
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CCA Tax Shield

Suppose we have C = capital cost of asset bought at t = 0 d = CCA rate for this asset class Tc = corporate tax rate r = discount rate In that case, the PV of the stream of tax shields is:
PV = C d Tc r +d

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2-208-97 Basic Corporate Finance

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CCA and Depreciation

Intuition: C d Tc is the savings in the first year. Growing perpetuity with growth rate of d. Effects of changing d The PV of the tax shield changes as d / (r + d) changes. Raising d raises PV and vice-versa. Fast depreciation a tax break for corporations.

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Straight-Line Depreciation
Most asset classes use the declining-balance (CCA based on UCC) method we have just seen. However, some special kinds of assets (pollution controls, patents, and some others) give straightline depreciation. You get CCA = d C for 1 / d years. PV requires an annuity formula instead of perpetuity.

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PV CCA Tax Shield

Effects of the half year rule:
0.5 C d Tc 0.5 C d Tc r +d PV = + r +d 1+ r C d Tc 1 + 0.5 r = r +d 1+ r

Effects of salvage value:

PV = C d Tc 1 + 0.5 r S d Tc 1 r +d r +d (1 + r )t 1+ r

Iwan Meier

2-208-97 Basic Corporate Finance

175

DCF Analysis: Tax Shield Approach

Required capital investment. Remember working capital: CF = year to year change in NWC. Recaptured at the end of the project. Operating cash flow: Operating CF = (Incremental revenues Incremental costs) (1 Tc) Remember to exclude financing charges.

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DCF Analysis: Tax Shield Approach (cont.)

PV( , , ) at the appropriate discount rate. Find the depreciation tax shield: If CCA big formulae. If straight line depreciation PV(annual tax shield) using annuity formula.

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177

Special Cases of DCF Analysis

The same techniques we have learned can be applied to a wide variety of business decisions: Evaluating cost-cutting proposals. Replacing an asset. Setting the bid price. Investment timing.
Evaluating equipment with different life.

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Evaluating Cost-Cutting Proposals

Example

St. Hubert Barbeque is deciding whether to invest in an online-ordering system that will require $5 million in new computer equipment but will reduce their labor costs from $7 million per year to $5.5 million per year for the next 5 years. The CCA rate for computer equipment is 35% and the companys tax rate is 25%. Should they buy the computer equipment? Solution technique: Exactly the same as what we have been doing. Focus on incremental cash flows.
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Replacing an Asset
Example

A university student painter is considering the purchase of a new air compressor and paint gun to replace an old paint sprayer (CCA rates: 30%). These two new items cost $7,000 and have a useful life of three years, at which time they can be sold for $600. The old paint sprayer can be sold now for $200 and could be scrapped for $150 in three years. The entrepreneurial student believes that operating revenues will increase annually by $6,000. Should the purchase be made? The tax rate is 22% and the required rate of return is 18%.

Iwan Meier

2-208-97 Basic Corporate Finance

180

Setting a Bid Price

Example

Consider a project to supply 40 million postage stamps to Canada Post for the next five years. You have an idle parcel of land available that cost $750,000 five years ago; if the land were sold today, it would net you $850,000. You will need to install $2.6 million in new manufacturing plant and equipment to actually produce the stamps; this plant and equipment will be depreciated straight-line to zero over the projects five-year life. The equipment can be sold for $380,000 at the end of the project. You will also need $600,000 in initial net working capital for the project, and an additional investment of $50,000 in every year thereafter. Your production costs are 1.8 cents per stamp, and you have fixed costs of $600,000 per year. If your tax rate is 34% and your required return on this project is 15%, what is the lowest bid price you could submit on the contract?
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Investment Timing
Decision rule: The right time to purchase an ever-increasing NPV investment is indicated by the highest present value of future NPVs, found by discounting the estimated NPVs of projects made in future periods by the opportunity cost of capital.
Example

You can purchase an optical scanner today for $400. The scanner provides benefits worth $60 a year. The expected life of the scanner is 10 years. Scanners are expected to decrease in price by 20 percent per year. Suppose the discount rate is 10%. What is the best purchase time?
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Equipment With Different Lives

Examples

Suppose we can choose between a 3-year and a 6year life for our machinery. Suppose you can choose between three machines. Machine A costs $10K to buy, $1K/yr and lasts 2 years. Machine B costs $12K to buy, $1.1K/yr and lasts 3 years. Alternatively, you can overhaul your existing machine for $5K and it will last 1 more year. Your discount rate is 10%. What should you do?
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Equivalent Annual Cost (EAC)

Optional

Definition: The level cost per period that has the same PV as buying and operating the equipment (with all its associated CFs). We need to find an annuity with the same lifetime as our equipment that generates the same PV of costs. PV = EAC Annuity factor
EAC = PV Annuity factor

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What We Know Now

Two ways to measure cash flow from assets. Determining changes in net working capital. Capital cost allowance (CCA) calculations. Incremental cash flows matter. Definition of operating cash flow: Bottom-up approach. Top-down approach. Tax-shield approach. Computing PV of CCA tax shield. A few special cases of DCF analysis.
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