Determine properly .

the key to correct , successful economic evaluation work rests heavily on

experience with proper methods for the following evaluation point : 1) correct handling of all
allowable income tax deductions , especially depreciation , amortization , depletion and deferred
deductions to determine correct taxable income , 2) adding back to net profit the proper non – cash
deductions to obtain cash flow (deffered deductions , amortized research and development
expenses , and special tax writeoffs are add – back items most frequently mishandled , 3) proper
handling of tax considerations for costs that may be written off for tax purposes in the year in which
they are incurred against other income rather than being capitalized and deducted over a period of
time greater than one yar , 4) correct accounting for tax effects on salvage value , either tax to be
paid or tax writeoffs to be taken ( in some invesment situations such as land invesment , salvage
value may be the major project income so it is imperative the salvage tax considerations be handled
correctly to get valid analysis results) , 5) proper handling of incremental invesment tax
considerations when lookng at differences between alternatives , such as in replacement analysis.

Example 8-6 sensitivity of DCROR and NPV analysis to invesment tax credit , deprecitation life ,
working capital and salvage value .

consider the investment of $1,000,000 at time zero to generate sales and operating costs per year of
$800,000 and $200,000 respectively for years 1 to 10 , assuming a washout of operating cost and
sales revenue escalation per year . assume year 10 salvage value wiil be zero , use a 40 % effective
income tax rate and determine the project DCFROR and NPV for i* = 20 % for the following
evauation situations.

a) The $1,000,000 time zero capital cost is for depreciable real property buildings , so the
invesment tax credit is not applicable . use straight line depreciation over 10 years.
b) The $1,000,000 time zero capital cost is for depreciable tangible personal property , so the
10 % invesment tax credit is applicable / assume the tax credit is taken at time zero when
the asset is put in service and carried forward to be used against project tax paid in year 1 .
compare these result with those assuming tax is being paid on other income against line
depreciation over 10 years.
c) Make the “a” evaluation assumning the allowable depreciation life is “5” years although the
evalution life is still 10 years . use a zero salvage for straight line depreciation over 5 years.
d) Make the part “a” evaluation assuming the $1,000,000 time zero cost is development cost
that can be expensed as an operating cost in the year incurred. Assume other income does
not exist againts which to use the deduction so it must be carried forward and used against
project income.
e) Now analyze the effect on the part “a” evaluation of adding $100,00 working capital cost at
time zero and $100,00 working capital return at the end of year 10.
f) Finnaly , analyze the effect on the part “a” evaluation if the actual salvage value is $400,00
instead of zero , assuming the assets are tangible personal property such as machinery and
equpiment so the capital gain due to depreciation to a zero book value is taxed as ordinary
income

Solution .,
All value in thousands of dollars/

a) ;;
b) Since the depreciation life is greater than 5 years , the full $1,000,000 qualifies for the 10%
invesment tax credit , giving : tax credut 10($1,000,000) = $100,000 = cash flow every dollar
of tax credit saves a dollar of tax , so it increases cash flow by a dollar , again , the following
diagram and equation values are in thousands of dollars . Note that the tax credit benefit is
shown in year 1 when the credit is actually used.
.
.
.
.
If the tax credit can be used againts tax paid on other income at time zero : .
..
c) ......
d) Treat the development cost as an operating cost.
.
.
.
.
.

Note that in going from part “a” for depreciation over 10 years to part “c” depreciating over 5 years
to part “d” expensing the cost at time zero , the analysis results keep getting better. Projec
economics are enhanced by getting tax deductions and therefore tax benefits as quickly as possible .

e) .....
The effect of working capital invesment is to lower DCFROR unless working capital return is
much greater than original invesment.
f) ....
Note that in case the salvage had a very insignificant effect on DCFROR . it would have had a
greater effect if the project DCFROR was no so large without the salvage , or if the salvage
occured closer to time zero , or if salvage was larger relative to the commulative cash flow.

EXAMPLE 8-7 illustration of DCFROR and NPV Analysis

A scientist estimates that the investment of $50,000 in analytical research equipment will allow him
to generate annual escalated dollar income of $40,000 before operating expenses of $15,000

Assuming a washout of escalating operating cost and income . He will also need invest %5,000 in
working capital for raw materials and sprare parts. Research equipment is depreciated over 3 years
using 1984 ACRS rates . salvage value is estimated to be zero 10 years from now. Working capital
return in 10 years is estimated to equal $5,000. Assume that the scientist will operate the business
a Corporation and that this the only corporate project . calculate the DCFROR and NPV for the
invesment if i* = 20 % after tax . assume that invesment tax credit is taken in year 1 and utilized as
soon as possible thereafter .
Solution: calculate annual cash flow, DCFROR and NPV . Note the working capital is not tax
deductible, and thus does not affect the income tax calculation .also since the working capital return
in this example is assumed exactly recover the original working capital investment, to not taxable

--- -------- - ----------------------

EXAMPLE 8.8 A Mineral Project Evaluation Using DCFROR and NPV*

A mineral reserve in the 22% depletion category contains 500,000 tons of more . it will be mined
uniformly over the next 5 years , 100,000 tons per year . The ore can be sold for $25.00 per ton in
the first operating year, with price projected to escalate 5% annually, thereafter . The mineral rights
are to be acquired with a $900, lump sum lease bonus payment at time “o” . Mine development
costs of $1.5 million , inventory woking capital costs of $300,000 and depreciable equipment costs
of $1 million are also incurred at time zero . depreciate the equipment over 5 years using the 1986
ACRS rates (DDB switching to syd ). Annual operating costs in year 1 are estimated to be $1 million,
escalating by $150,000 annually in years 2-5. The property and equipment are expected to have no
net salvage value , although a recovery of the $300,000 in working capital by inventory liquidation
will occur at the end of year 5. Assume this corporation has an effective tax rate of 50% (neglecting

lower rates on taxable income below $100,000 per year ) and no other corporate income. Thus, any
losses from mine development must be carried forward to be deducted against mining income. The
10% investment tax credit on depreciation able equipment cost at year 0 must also be carried
forward and used against actual tax project liability .

a) What DCFROR does this firm earn on its investment?

b) if other opportunities exist to invest at 20%, what is the project NPV?

------- ------------

oil and gas evaluations for a company or individual are evaluated similarly to mineral projects.
Mineral development costs are the equivalent ot intangible Drilling costs and mining equipment is
equivalent to oil and gas producing equipment. Percentage depletion rates differ for various
minerals and oil/gas, and a petroleum company or individual with greater than 1000 barrels of oil

production per day is eligible only for cost depletion on oil and gas production. Windfall profit
(excise) tax is treated as an operating cost for all size petroleum producers. Problems 8-8 and 9-2
cover oil and gas analysis considerations.

Solution: All Values in Thousands of Dollars

----------------- ---------------

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PROBLEMS

8-1 .

A man invest, $ 22.000 in a repair business including $2000 for working capital for spare parts, He
estimates that he can sell the business in 3 years for SI4,000 including the S2000 working capital
return. The man plans to depreciate the S20,000 non-working capital investment using a 5.year
depreciation life. Expected annual income is $ 15.000 and operating costs are expected to be $5000
per year. Taxable income from the business will be taxed at an effective rate of 40% Assuming the
business will be sold in 3 years for the estimated $ I4,000, calculate DCFROR for a 3-year evaluation
life. Neglecting investment tax credit , for :

a) straight line depreciation using the half-year first year convention,

b) 150% declining balance method with the half year depreciation convention in the first year.

c) Using the 1986 ACRS depreciation rates.

8-2.

A man has S80,000 invested in a duplex. He expects annual profits before tax from this investment
over the next 10 years to be $8000 per year with a salvage value of $80,000 at the end of year ten.
He expects to reinvest the duplex investment profits in common stock investments that he projects
will compound at a 20% rate before tax. If the tax rate is 30%, determine the overall growth rate
over the next 10 years on the man's $80,000 investment assuming no depreciation is taken in any
tax year and that ordinary income tax is paid each year on stock trading profits that give the 20%
growth rate before tax. Then work the problem assuming tax is deferred to the end of year 10 when
a lump sum gain from the sale of common stock will be realized.

8.3 .

Development of a coal property which our company purchased two years ago for a mineral rights
acquisition cost of $ 10 million is being considered . our company does not have other income
againts which to use tax deductions ,so we must carry forward negative taxable income that occurs
from expensing development costs incurred in year 0. Mineral development capital of $ I0 million is

needed now (evaluation year 0) for overburden stripping. Mine equipment cost of $ 15 million alsp
will be incurred in year 0 along with $ 2 million cost for working capital . The mine life is estimated to
be 5 years . Mine equipment will be depreciated over 5 years using 1986 ACRS rates (DDB
Depreciation switching to sum of years digits). Salvage value and working capital returns will be $5
million at the end of year 5 and taxable gain is taxed as ordinary income. The effective tax rate is 50
% . The investment tax credit applicable on the mine equipment cost in year 0, with the max credit
to be curried forward and used against project ta. x Coal reserves are estimated to be 5,000,000 tons
and production for years 1 through 5 is projected to be 1,000,000 tons per year. Coal selling price is
estimated to be $ 30 per ton in year 1,escalating 10 % per year in years 2 through 5. Mining
operating costs are estimated no be $ 12 per ton in year 1 , also escalating by 10 % per year in
following years . use a 50 % effective income tax rate and calculate the project DCFROR and NPV fo
a minimum DCFROR of 20% to determine if the mine development economics are satisfactory.

8-4.

A scientist estimates that investing $ 50,000 in analytical research equipment will allow him to
generate annual escalated dollar income of $40,000 before operating expenses of $ 15,000,
assuming a washout of escalating revenue and operating costs He must also invest $ 5000 in working
capital for raw material stocks and spare parts . The equipment cost is depreciable over 3 years using
1984 ACRS rates. Salvage value is estimated to be zero 10 years from now, except that liquidation of
inventories at year 10 will return the $ 5000 working capital investment .

a) Assuming the scientist will run the enterprise as a corporation and this is the only corporate
income, compute year 0 through 10 cash flows, the project DCFROR, and the project NPV assuming
I* = 20 %

b) For the same business situation (a), compute the growth rate of return on invested dollars if the
scientist invests all positive cash flow in a money market fund that will yield 12% before tax annually
. Assume tax will be paid at an effective 40 % rate on interest income each year .

8-5.

A manufacturing plant can be purchased for $180,000 an additional $20,000 must be invested in
working capital for raw material and spare parts inventory and accounts receivable money tied up in
operating costs. The $ 180,000 plant cost will be depreciated straigh line over 15 years using the half
year depreciation will convention in year . Actual salvage value is estimated to be $ 150,000 and
assume it is for machinery and equipment . working capital return is estimated to equal $ 20,000 at
the end of year . Annual sales revenue are projected is estimated to be $100,000 year 1 with
operating costs of $40,000. In years 2 to 15. escalation of operating costs and sales revenue are
projected to be a washout . the effective income tax rate is 45%. The investment tax credit will be
applicable to $125,000 worth of used equipment included in the initial purchase price and the tax
credit will be used in year .l. The minimum ROR is 15% after-tax.

a) Calculate project DCFROR and NPV

b) Change the project life and depreciation life to 25 years with all other parameters the same and
calculate DCFROR and NPV

8-6.

A mining company is considering buying the mineral rights to a small mica property. The mineral
rights acquisition cost will be $1,000,000 in year 0 and depreciable mining equipment costs will be $
1,000,000 in year l escalated dollars. The depreciable costs will be depreciated over years 2 through
6 using 1986 ACSR 5 year depreciation rates, The acquisition cost is not depreciable but must be
capitalized into the cost depletion basis. Salvage value of all assets is considered to be nil. Production
rates will be 100,000 yr in years 2 and 3 and 150,000 unit/yr in years and 6 which will deplete the
reserves. The mica product will be for sol for $15/ unit while production operating costs are
estimated to be $6/unit. Assume a washout of escalation of operating cost and sales revenue and
neglect the effect of escalating sales revenue on percent depletion . A production startup
develepment cost of $ 300,000 will be incurred in year 2 and deducted for tax purposes as an
operating cost at the end of year 2 . the effective income tax rate is 48% and invesment tax credit
will be taken in year 1 on depreciable equipment costs and carried forward and used againt tax paid
on project income in years 2 and 3 .

A) Determine project cash flow for year 2 through 6

B) What is the project DCFROR for the 6 year evaluation lfe ?
 C) What is the project NPV for i* = 20 % ?

8.7

A real estate broker who makes his living by buying and selling properties is evaluating the purchase
of 10 acres of land for $60,000 cash now to be sold in the future for a profit . what excalated dollar
sale value must the land have in two years to give a constant dollar invesment DCFROR of 20% per
year if annual inflation is prjected to be 10 % ? assume that the capital gain frow the land sale will
be taxed as ordinary income at an effective tax rate of 50% . the repeat the analysis assuming the
gain is taxed as an individual long term capital gain.

8-8.

A small newly formed company plans to acquire the mineral rights to a petroleum proper for
$50,000 and to immediately spend $400,000 on intangible drilling costs for an exploration well . if
the drilling is successful , well completion and equipment costs of $240,000 will be incurred which
will be depreciated using 1986 ACSR 5 year depreciation rates although the well is estimated to
have a 12 year production life. Oil production year ls projected to be 20,000 barrels per year after
royalties in year 1 . To simplify the analysis assume a selling price of $ 33 per barrel after royalties in
year 1 , but before $7 per barrel wind fall profit tax in year 1 and that revenues and windfall tax are
the same number in years after year 1 . operating costs are estimated to be $80,000 in year 1 and
succeeding years. Consider that this project represents the only company income and the $400,000
intangible drilling cost incurred at time zero will be expensed at time zero and carried forward as a
loss forward deduction until completely used. Investment tax credit will be taken on the year zero
$240,000 depreciable well completion costs and carried forward to be used against project tax as
soon as possible. This will be the only producing property of the company so the larger of percent
and cost depletion may be taken. Use the 15% depletion rate applicable in 1984. Crude reserves are
estimated to be 200,000 barrels for cost depletion calculations in year 1. The effective tax rate is
50%. Neglect salvage value 12 years from now. Use NPV analysis for 12 year project life to evaluate
if the project is economically satisfactory for an after-tax i* of 15% assuming zero risk. Then calculate
expected NPV assuming a 60% probability of success and zero net cash flow if failure occurs.

8-9.

The investment of $450,000 at time zero for machinery and equipment depreciated using 5 years
straight line ACRS rates in expected to generate sales of $400,000 per year less operating costs of
$200,000 per year . escalation of operating cost and sales revenue is expected to be a washout from
year to year . $100,000 for working capital invesment is also needed at time zero and working capital
return is expected to equal the initial investment at the end of the project. Salvage value of the
machinery and equipment is expected to be zero. The minimum ROR. I* equals 15% after-tax and
the effective income tax rate is 50%. Calcula DCFROR and NPV for

a) Neglecting investment tax credit and using a 9 year evaluation life

b) Including investment tax credit by taking it against project taxes to be paid in year 1 for a 9 year
evaluation life.

c) Including investment tax credit by taking it against project taxes to be paid in year 1 for an 18 year
evaluation life (still use a 9 year depreciation life )
d) Neglecting investment tax credit and using an 18 year evaluation life.