Tutorial Sessions 7 Winter 2017

Cash Flow Estimation & Capital

Budgeting Decisions
(CH. 14)

COMM 308- Tutorial Session 7 1

Agenda

Equivalent Annual NPV approach (EANPV)

Cash Flow Estimation Procedures and Steps
Capital Cost Allowance (CCA)
Capital Cost Allowance Tax Shield (CCATS)

COMM 308- Tutorial Session 7 2

 Evaluating Investment Alternatives
(Independent and Interdependent Projects)
Case where the project are independent:
Projects are said to be independent, if accepting one has no
impact on the acceptant of the other project.
In case the projects are independent, as long as there is no capital
expenditure restrictions, the rule should be to accept the projects
that have the positive NPV.

Case where we have contingents projects:

Contingent projects are those for which acceptance of one requires
the acceptance of another
A firm takes a set of contingent projects in case their TOTAL NPV is
positive.

COMM 308- Tutorial Session 7 3

 Evaluating Investment Alternatives
(Independent and Interdependent Projects)
Case where the project are Mutually Exclusive:
In case we are faced with mutually exclusive projects, we have to
select one among all the others.

If all the projects have similar time horizons, then we pick the one
with the highest NPV, assuming that it is positive.

If the projects have different time horizons, we have to rely on one

of the two approaches below to compare them:
1. Chain Replication Approach [Not covered]
2. Equivalent Annual NPV (EANPV)

COMM 308- Tutorial Session 7 4

 Evaluating Investment Alternatives
(Independent and Interdependent Projects)
2. Equivalent Annual NPV approach

Find the Net Present Value of the Individual Projects

Determine the annuity amount that is economically equivalent to the

NPV generated by each project over its respective time horizon

=
1
1
(1 + )

COMM 308- Tutorial Session 7 5

 Evaluating Investment Alternatives
(Independent and Interdependent Projects)
Company XYZ is lost between three projects: A, B, and C. A requires an
initial investment of $10,000 and generate $7,000 for the coming two
years. B requires $15,000 and generate $6,500 for the coming three
years. C requires an initial investment of $20,000 and generates $6,000
for the coming 6 years. A, B, and C are mutually exclusive. Which
project should XYZ take if its discount rate is 14%?

NPVA = 1,526 (found previously)

1,526
= = 926.74
1
1
(1 + 0.14)2
0.14

COMM 308- Tutorial Session 7 6

 Evaluating Investment Alternatives
(Independent and Interdependent Projects)
(cont.): Company XYZ is lost between three projects: A, B, and C. A
requires an initial investment of $10,000 and generate $7,000 for the
coming two years. B requires $15,000 and generate $6,500 for the
coming three years. C requires an initial investment of $20,000 and
generates $6,000 for the coming 6 years. A, B, and C are mutually
exclusive. Which project should XYZ take if its discount rate is 14%?

NPVB = 90.6 (found previously)

90.6
= = 39.024
1
1
(1 + 0.14)3
0.14

COMM 308- Tutorial Session 7 7

 Evaluating Investment Alternatives
(Independent and Interdependent Projects)
(cont.): Company `xyz` is lost between three projects: A, B, and C. A
requires an initial investment of $10,000 and generate $7,000 for the
coming two years. B requires $15,000 and generate $6,500 for the
coming three years. C requires an initial investment of $20,000 and
generates $6,000 for the coming 6 years. A, B, and C are mutually
exclusive. Which project should XYZ take if its discount rate is 14%?

NPVC = 3,332 (found previously)

3,332
= = 856.85
1
1
(1 + 0.14)6
0.14

COMM 308- Tutorial Session 7 8

 Evaluating Investment Alternatives
(Independent and Interdependent Projects)
(cont.): Company XYZ is lost between three projects: A, B, and C. A
requires an initial investment of $10,000 and generate $7,000 for the
coming two years. B requires $15,000 and generate $6,500 for the
coming three years. C requires an initial investment of $20,000 and
generates $6,000 for the coming 6 years. A, B, and C are mutually
exclusive. Which project should XYZ take if its discount rate is 14%?

Project Name EANPV

A 926.74
B 39.024
C 856.85
Project A should be selected.

COMM 308- Tutorial Session 7 9

Project Cash Flows

Some notes about net working capital:

Net working capital = accounts receivable(a.r.) accounts

payable(a.p.)

Change in NWC(in one year) = NWC 1 NWC 0

Change in NWC(in one year) = (a.r.[t=1] a.r.[t=0])

(a.p.[t=1] a.p.[t=0])

COMM 308- Tutorial Session 7 10

 (SummerI 2013, Q. 27)
The following information was reported last year. What was the change in
cashflow (due to changes in net working capital) for the year?
A. -$9,138
B. -34,662
C. $9,138
D. $34,662
E. None of the above

Ans.: A (Inventory is like accounts receivable)

Change in NWC: 10088-12762+11812= 9138

Change in cash flow = -9138

COMM 308- Tutorial Session 7 11

Project Cash Flows

So far, the question gave us our cash flows of the project

in each period (our timeline was there, for free!), so we
solved the problems based on given cash flows of each
period (Calculating NPV, PI, IRR etc. )

What if cash flows are not given?!

They give us some information about the project, we can

find the cash flows of each period ourselves, and then
we can proceed to solve the problem as before!

COMM 308- Tutorial Session 7 12

Problem
A proposed new project has projected sales of
$108,000, costs of $51,000, and CCA (i.e.,
depreciation) of $6800. The tax rate is 35
percent. Calculate operating cash flow using the
four different approaches described in the
chapter and verify that the answer is the same in
each case.

COMM 308- Tutorial Session 7 13

Solution

To calculate OCF for a given year, first step is to

make the Statement of Comprehensive income:

COMM 308- Tutorial Session 7 14

Solution(continue)

1) Most common approach:

OCF = EBIT+Depreciation Taxes = 50,200 +6,800
17,570 = $39,430
2) Top-Down approach:
OCF = Sales Costs Taxes = 108,000 51,000 17,570
= $39,430
3) Tax-Shield approach:
OCF = [(Sales Costs)*(1-Tr)] + [Tr * Depreciation] =
($108,000 51,000)(1 0.35) + 0.35(6,800) = $39,430
4) Bottom-Up approach:
OCF = Net income + Depreciation = $32,630 + 6,800 =
$39,430
COMM 308- Tutorial Session 7 15
 PV(Operating CFs)
Tabular by year Revenues (sales)
+CCA tax shield Variable and Fixed Costs
(if tax shields equal for Operating Expenses
every year)
- additions to NWC
!!! OR !!! Operating Income
Taxes
+PVCCATS
(if tax shields not After-Tax Operating Income
equal for every
year) + [CCA Expense(t) x Tax Rate]
OCFt
If CFs are equal over the years, use annuity after tax:

COMM 308- Tutorial Session 7 16

 Important:
We either calculate cash flow of each year
separately and then get PV of all of them.

Or we get PV of each part of cashflow of each

year separately and add them up!

NPV = CF0 (which is a negative number) +

PV(OCFs(without depreciation/tax shield part) + PV()+
PV(NWCrecapture) + +

COMM 308- Tutorial Session 7 17

PV( CCATaxSheild)

As shown in slide 16&17, There are two ways to calculate CCA Tax
Sheild
1. Tabular Amortization
For each year calculate:
CCATS = CCA*Tax rate, where
CCA= Beginning undepreciated capital cost * CCA rate
Ending undepreciated capital cost = Beginning underpreciated
capital cost CCA
Beginning balance = previous years ending balance.
Dont forget the half-year rule!

COMM 308- Tutorial Session 7 18

 CCA review - Winter 2013, Q. 18

A firm purchases Class 8 equipment for $1,000,000 (CCA Rate 20%) for
a 10 year project. What will be the CCA tax shield in year 3? The tax rate
is 35%.
A. $201,600
B. $144,000
C. $63,000
D. $50,400
E. $35,000

Ans.: D

COMM 308- Tutorial Session 7 19

 (Fal1 2013, P.2)
Q2. (10 Points) This question has two related parts. Information from (i) may be used in
(ii)
Your younger cousin is about to enter Concordia University, and she is going to start her
own used textbook business while she is in college. The business will only last for 4
years. The building will cost $120,000 today to purchase. She expects to sell the building
4 years from now for $60,000. She expects annual revenues (starting next year) of
$45,000. Her operating costs (including salaries, overhead expenses, shelving, etc.) will
be $14,000 per year. Her working capital level requirements will be $10,000 immediately,
$15,000 in the first and second years and $5,000 in the third year. She will not need any
working capital at the end of the year four period. She asks you for advice regarding this
venture should she do it?
For simplicity ignore CCA and assume that she can depreciate the building by $15,000
each year for four years. Assume that the appropriate discount rate for this project is 10%
and the corporate tax rate is 30%.
To assist you in your analysis, we have provided you with a partially completed cash flow
estimation table corresponding to the above problem. Complete the table by calculating
the missing numbers (letters a through t). Should she do it?

COMM 308- Tutorial Session 7 20

(Fal1 2013, P.2) Cont.

COMM 308- Tutorial Session 7 21

(Fal1 2013, P.2) - Solution

It was 0, now its 10, 000 (so 10,000 addition,

so the sign should be negative)

COMM 308- Tutorial Session 7 22

Approaches for Dealing with CCA when
Determining OCF
2. Tax Shield Approach calculate the PV of CCATS
separately using the formula and exclude CCATS
from annual cash flows (OCF*)
OCFt * St Ct 1 Tc
Again, for each year you have an OCF (ocf1-ocf2 etc. ), timeline ready, proceed [e.g. get
NPV] but dont forget below [ add PVCCATS to the NPV that you have gotten]
Then Calculate the PV of the CCA Tax Shield

C0 dT 1 0.5k SdT 1
PV CCA Tax Shield n
d k 1 k d k 1 k

COMM 308- Tutorial Session 7 23

(2010 Final Exam, Q.4)
Magnana Inc. is considering a new 4-year project. The
project will require purchase of new equipments costing
$60,000. After 4 years these can be salvaged for $15,000.
The CCA rate is 25%. Revenues are expected to grow at 5%
per year, starting with $10,000 in year 1. The expected costs
are $5,000 per year. Inventory will increase immediately by
$10,000. Accounts receivable are expected to be 10% of
revenues and accounts payable are expected to be 10% of
costs, each year. Assume that all the net working capital will
be recaptured in year 4. Magnanas WACC is estimated at
10% and their tax rate is 40%.
A. What is the present value of the CCA tax shields?

COMM 308- Tutorial Session 7 24

 2010 Final Exam, Q.4, solution:

60,000 0.25 0.4 1 + 0.5 0.1 15,000 0.25 0.4 1

) =
0.25 + 0.1 1 + 0.1) 0.25 + 0.4 1 + 0.1)4

() = 13,436.4

COMM 308- Tutorial Session 7 25

(Fall 2011, Q.2)
Patterson, Inc. is considering the replacement of an old machine. The old
machine, which was purchased 5 years ago, has book value of $63,000 today
and an expected remaining useful life of four years. The firm could sell it for
$60,000 today or $10,000 in four years. The new machine costs $280,000. It
has a useful life of four years and a salvage value of $18,000. Both machines
fall into asset class 39, which has a CCA rate of 25%. The new machine will
increase sales by $85,000, $90,000, $80,000, and $70,000 in years 1, 2, 3, and
4 respectively. The firm must invest $5,000 in NWC today, and then NWC must
be maintained at 10% of sales revenue. The discount rate is 8% and the tax
rate is 40%. What is the PV of CCA tax shield?

COMM 308- Tutorial Session 7 26

Problem

A new Electronic process monitor costs $990,000. This

cost could be depreciated at 30 percent per year (class 10).
The monitor would actually be worthless in five years. The
new monitor would save 460,000 per year before taxes and
operating costs. If we require 15 percent return, what is the
NPV of the purchase? Assume a tax rate of 40 percent.

COMM 308- Tutorial Session 7 27

Solution

Some important remarks!

So far, we had a ready timeline. The questions were about
PV of a series of cash flows, or NPV of a project with given
cash flows. In chapter 14, we learn how to calculate the
cash flows of each year ourselves, then draw our timeline
and then calculate the NPV of the project (one more step,
now!)
*Total Cash flow of each year typically include three
numbers:
= + +

COMM 308- Tutorial Session 7 28

*Most of the times the OCF= (sales costs)*(1-Tr) [ignore
the tax shield part] is the same for each year or there is
some pattern (so we can get the PV of all of them using PV
of annuity/growing annuity etc. formulas).
*Change in net working capital for each year is defined as:
= 1 , so it can be a positive or
negative number. If they are different for different years,
then we have to discount them back one by one, add them
up and get the total PV0 of them

COMM 308- Tutorial Session 7 29

Solution(Cont)

*For tax shield of each year, we just ignore them and dont
calculate them one by one (we can do that but it is very
time consuming especially if you have a large number of
years). We have a big formula that will give us the PV0 of
all of the tax shields of different years, combined.

*Initial investment takes place at t=0 on our timeline.

COMM 308- Tutorial Session 7 30

Solution(Cont)

*If we need NWC immediately at t=0, So the 0 =

1 0 = 0 and we can continue calculating
for every year from t=1, one by one.
In this case our CF0 = -initial investment - 0
*If not stated in the question, the NWC is recaptured,
meaning that at the last period you will have a positive
number in amount equal to [-0 + =1 ]-but
positive- and you have to discount it back to t=0.
*If there is salvage value, it is on your last period and you
have to discount it back to t=0.

COMM 308- Tutorial Session 7 31

Solution(continue)

So, NPV = CF0 (which is a negative number) + PV(OCFs) +

PV()+PV(NWCrecapture)
+ +
Here in this question we have no NWC, there is no salvage
value (worthless in five years). We just have:
CF0 = -990,000
OCF1,OCF2,OCF3,OCF4, and OCF5 (If you notice they will
be same numbers for every year, here in this question(it is
often the case). Good for us! We can get the PV0 of them all
at once with PV of annuity formula)
PVCCATS (its just one formula, and we have every
information to calculate it)

COMM 308- Tutorial Session 7 32

Solution(continue)

OCF1 = OCF2 = OCF3 = OCF4 = OCF5 = 460,000(1 0.40) = $276.000

(careful! the 460,000 given in the question is before tax as stated)
276000 1
15) = 1 = $925,194.80
0.15 1 + 0.15 5
0
= $246,782.61

C0=initial investment = 990,000 d=0.30 T=0.40 k=0.15 SV=0

NPV = -990,000 + 925,194.80 + 246,782.61 = $181,977.42

COMM 308- Tutorial Session 7 33

Problem

We believe we can sell 90,000 home security devices per

year at $150 a piece. They cost $130 to manufacture
(variable cost). Fixed production costs run $215,000 per
year. The necessary equipment costs $ 785,000 to buy and
would be depreciated at a 25 percent CCA rate. The
equipment would have a zero salvage value after the five-
year life of the project. We need to invest $140,000 in net
working capital upfront; no additional net working capital
investment is necessary. The discount rate is 19 percent,
and the tax rate is 35 percent. What do you think of the
proposal?

COMM 308- Tutorial Session 7 34

Solution

Remember our approach:

NPV = CF0 (which is a negative number) + PV(OCFs) + PV()+
PV(NWCrecovery)+ +
Now, lets do it step by step:
CF0 = -initial investment - 0 = -785,000 140,000 = -$925,000
For PV(OCFs) first we need to calculate OCF for each year (which are
equal):
15 = (sales costs)*(1-Tr)
Sales = 90000*150=13,500,000 Costs=Variable + Fixed=
(90,000*130) + 215000 = 11,915,000
15 = (13,500,000 11,915,000)(1 0.35) = $1,030,250
1,030,250 1
15) = 1 = $3,150,128.34
0.19 1 + 0.19 5

COMM 308- Tutorial Session 7 35

Solution(continue)

PV() = 0 as we have no NWC and as a result no in our

timeline
+140,000
PV(NWC recovery)= = 58,666.9 as the question does not
1+019)5
mention it, we always assume that the net working capital in our project,
is going to be recovered (a positive number) at the end of project (t=5).
We want the PV0 of that amount, so we discount it for 5 years.
= 0 (given in the question: at t=5 the equipment has
a zero salvage value)

= 0 = 785,000, d = 0.25, T = 0.35, k

COMM 308- Tutorial Session 7 36

Fall 2014

COMM 308- Tutorial Session 7 37

Fall 2014-Sol

COMM 308- Tutorial Session 7 38

Summer1- 2014

COMM 308- Tutorial Session 7 39

Summer1- 2014-Sol.

COMM 308- Tutorial Session 7 40

Summer1-2015 / Q2

COMM 308- Tutorial Session 7 41

Summer1-2015 / Q2

COMM 308- Tutorial Session 7 42

Summer1-2015 / Q2-Alternative Method

COMM 308- Tutorial Session 7 43

Good Luck!

COMM 308- Tutorial Session 7 44