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CHAPTER 8: DISCOUNTED CASH FLOW ANALYSIS

A. OVERVIEW Motivation: How to determine CF? What should we include? Recall: Components in cash flows 1. Initial investment • Relevant cash outflows now to embark on a capital budgeting project • Installation + acquisition 2. Operating cash inflows • The incremental after-tax cash inflows resulting from the operation of a project during its life • Change in the (net) working capital 3. Terminal cash flow • The after-tax non-operating cash flow at the final year of the project (liquidation of the project) • Salvage value + tax benefits forgone

Example A firm is considering replacing an existing machine. The new machine costs $1.2 million and requires installation costs of $150,000. The existing machine can now be sold for $185,000. It is 2 years old, cost $800,000 new, and has a $384,000 book value and a remaining useful life of 5 years. If held over 5 years, the market value will be $0. Over the 5 years, the new machine will reduce operating costs by $350,000 per year. The capital cost allowance rate on the machine is 30%. The new machine can be sold for $200,000 net of removal and clean up costs at the end of 5 years. An increased investment in net working capital of $25,000 will be needed to support operations if the new machine is acquired. The firm has a 9% cost of capital and a 40% tax rate. Identify the different components of cash flows. Suppose firm receives a 10% investment credit. (Ignore tax implications of terminal loss.) Which “numbers” are relevant? Which ones are not? B. RULES OF THUMB: WHAT IS RELEVANT? 1. Types of costs: • Sunk cost: Past outlays that have no effect on cash flows • Opportunity cost: Cash flows that could have been realized from the best alternative forgone • Indirect costs/benefits: Changes in cash flows in other lines of operation if the project is accepted Rule 1: Sunk costs do not matter. Include opportunity costs and all indirect effects.

Example (12-30) The old machine is 2 years old, cost $800,000 new, and has a $384,000 book value and a remaining useful life of 5 years. • • Changing the $800,000 cost (2 years ago) would not affect the cash flows of the new machine. If the old machine can be deployed to produce part of the goods, which reduces operating costs of using the new machine alone, then the forgone cost savings is an opportunity cost.

2. Types of cash flows: • Financial cash flows: Interest, lease payments, dividends • Operating cash flows: Operating costs (variable / fixed costs) that affect EBIT Assumption Financing decisions are made separately and have been made to determine the cost of capital. The cost of capital will then used to calculate the present value. Rule 2: Include operating cash flows only. Including financial cash flows would double count financial costs. 3. Changes in net working capital: • Net working capital = Short-term assets – short-term liabilities • Short-term assets: cash, A/R, inventories • Short-term liabilities: A/P, notes payable, accruals Rule 3: Include changes in net working capital and recapture and change at the end of the project. Rules of thumb (summary): • Include opportunity costs. Ignore sunk costs. • Include all indirect effects. • Use operating cash flows. Ignore financial cash flows. Use cost of capital to discount. • After-tax cash flows matter. • Incremental costs matter: “marginal” – comparing among projects (replacement projects) • Include changes in net working capital: readjust at the end of the project. C. DETERMINE INITIAL INVESTMENT Definition: Initial investment is the relevant cash outflows incurred if a capital budgeting project is implemented. – Acquisition costs: outlays to purchase equipment – Installation costs: install the equipment to get it into operation Definition: Incremental cost of a new asset is the total initial investment less the after-tax proceeds from the sale of an old asset (replacement project) Definition: Change in net working capital is the difference between the change in current assets and the change in current liabilities associated with the project – Mathematical adjustment of the value of tied-up / freed funds – Considered as funds tied-up during the life of the project • Affects time t=0 and t=end of project if liquidated • What if not liquidated? – Increases in current assets : uses of cash – Increases in current liabilities: sources of cash – Change in net working capital > 0 à cash outflow at time t=0 – Change in net working capital < 0 à cash inflow at time t=0

Net working Capital Increases outflow at t=0 inflow at t=N Components in initial investment (summary) • Acquisition costs of assets • Installation costs of assets • Less after-tax proceeds from selling old assets • Add changes in net working capital (if positive) • (Less changes in net working capital (if negative)) D. DETERMINE TERMINAL CASH FLOWS Definition: Salvage value is the funds received when the project terminates and assets sold. – Sale of assets (after-tax) – Includes removal / clean-up costs incurred Components in terminal cash flows: • Salvage value (after-tax) from selling assets – Includes removal / clean-up costs • Changes in net working capital (if one-time adjustment) • Discount to t=0 to obtain present value E. DETERMINE THE CASH FLOW Components in cash flows: 1. Incremental after-tax operating incomes 2. Capital cost allowances 3. Investment trade credits 4. Other government incentives Definition: Incremental after-tax operating incomes refers to changes in operating incomes by comparing the operating incomes of the old and new assets / after implementation of projects Definition: Capital cost allowances refers to amortization (depreciation), a non-cash expense that increases cash flow Definition: Investment tax credit (ITC) refers to tax incentives for purchasing certain types of assets (especially R&D), which reduces federal taxes payable Definition: Other government incentives include – cash grants (direct cash payments) – interest rate buydowns (government payments of interest on a loan on behalf of a company) – wage and rent subsidies (payment by government to employees / landlord) – tax breaks (reduced property taxes, income taxes) Decreases inflow at t=0 outflow at t=N

Components in incremental after-tax cash flows: Incremental sales Less: Incremental operating cost = Incremental operating income Less: Tax = Incremental after-tax operating income Add: Incremental tax shield from CCA Add: ITC / other government grants = Incremental after-tax cash flow 1. Determine incremental after-tax operating incomes: Incremental sales Less: Incremental operating costs = Incremental operating incomes Less: Taxes = Incremental after-tax operating incomes What if incremental after-tax operating income is not “given”? Example Suppose a firm is operating at $650,000 sales per year. Operating costs are 61% of sales. If new machine is purchased, the firm sells $1,000,000 with 40% of sales being operating costs. Tax rate is 30%. 2. Impact capital cost allowances (CCA): Notes: 1. CCA is a benefit since it is deducted from income when calculating taxable income, but cash is actually used 2. Canada Customs and Revenue Agency (CCRA) allocates all assets into various asset classes • Each class has a CCA rate • Use CCA rate to multiply into undepreciated capital cost (UCC) 3. “Half-year rule”: ½ of allowable CCA can be deducted in the year the asset is acquired 4. Benefit of CCA is the tax-shield (tax savings from non-cash expense) Tax shield = CCA * tax rate (note half-year rule) 5. Calculated based on incremental investment in machine 6. Easiest to set up a table 3. Investment tax credit and other government grants: Notes: 1. Based on qualifying expenditure times ITC rate 2. Direct benefit of the project 3. Cash inflow in year 1

Summary: Step 1: Initial investment (IC at year 0) Acquisition cost + installation cost – proceeds from selling old machine (= incremental cost of new asset) + (positive) changes in net working capital Step 2: Terminal cash flows (CF at end of project) Salvage value + changes in net working capital Step 3: Cash flows Incremental after-tax operating income + Incremental tax shield from CCA + Investment tax credits / other government incentives (year 1) Step 4: Treat terminal cash flow as end-of-project cash flow and discount all cash flows to year 0 Example A project requires an incremental cost of asset of $10,000. Annual cash flow is expected to be $2,000. The project has a useful life of 5 years. Assume that the firm keeps the asset after 5 years. Tax rate is 40%. WACC is 9%. Should the firm proceed with the project? Assume tax shield is included in cash flow. Example What if tax shield is not included, and the CCA rate is 30% of the incremental cost, $10,000? F. TWO OTHER CONSIDERATIONS 1. Quick formula for calculating total tax shield

 d * T  1 + 0.5 * k a  PV of tax shield from CCA = C     d + ka   1 + ka 
C = incremental cost of new asset, UCC resulting from an asset acquisition d = CCA rate for the asset T = tax rate Ka = cost of capital Note: C = Cost of project – proceeds from selling old asset - ITC Example A company constructs a new plant with a 4% CCA rate at a cost of $5 million. The plant has an expected life of 50 years. What is the PV of the total tax shield on this asset? Suppose tax rate is 32% and the cost of capital is 10%. Example Suppose the plant replaces an old one that receives a proceed of $300,000. The firm is qualified for ITC of 10%. Calculate the total present value of tax shield.

2. Salvage value of “new” machine at end of project Two impacts: a. Add So to NPV (So is the present value of the salvage value) b. Lose present value of tax shield

d = CCA rate for the asset T = tax rate Ka = cost of capital

 d *T  PV of tax shield loss = S 0    d + ka 

Example Suppose the new plant can be sold at the end of 10 years with a salvage value of $108,000. What is the impact on the NPV of project? A simpler example A project requires an incremental cost of asset of $10,000. Annual cash flow is expected to be $2,000. The project has a useful life of 5 years. Assume that the firm keeps the asset after 5 years. Tax rate is 40%. Opportunity cost of capital is 9%. Should the firm proceed with the project? Assume tax shield is included in cash flow. Example What if tax shield is not included, and the CCA rate is 30% of the incremental cost, $10,000? G. FINAL NOTE • Real cash flow should be discounted by a real discount rate, nominal cash flow at nominal rate. Example. After-tax cash flow is $15,000 a year for 3 years. Opportunity cost of capital is 12%. Cash flow increases at the rate of inflation of 3%. Cash flow Yr 1 15000 Yr 2 15000*1.03 Yr 3 15000*1.032

Discount rate of 12% or 9%?