Income Taxes in Capital

Budgeting Decisions
 LEARNING OBJECTIVES
After studying this chapter, you should be able to:
1. Compute the after-tax cost of a tax-deductible
cash expense and the after-tax benefit from a
taxable cash receipt.
2. Explain how capital cost allowance is
computed.
3. Compute the tax savings arising from the
capital cost allowance tax shield.
4. Compute the after-tax net present value of an
investment proposal.
5. (Appendix 15A) Measure risk in assessing
capital budgeting projects.
Income Taxes and Capital Budgeting

The effects of income taxes on cash flows

must be considered in capital budgeting
decisions when an organization is subject
to income taxes.

T2
The Concept of After-Tax Cost

Tax deductible expenses decrease the

company’s net taxable income and
reduce the taxes the company must
pay.

Let’s look at the East and West

Companies example.
East &
West
The Concept of After-Tax Cost

East and West Companies are identical except that

East has a $40,000 annual cash expense for an
employee training program.
East West
Company Company

Sales $ 250,000 $ 250,000

Less expenses:
Salaries, insurance, etc. 150,000 150,000
Training program 40,000 -
Total expenses 190,000 150,000
Income before taxes 60,000 100,000
Less: income taxes (30%) 18,000 30,000
Net income $ 42,000 $ 70,000
The Concept of After-Tax Cost

East and West Companies are identical except that

East has a $40,000 annual cash expense for an
employee training program.
East West
The
The after-tax
after-tax cost
cost of
of Company Company
the
the training
training program
program
is
is $28,000
Sales ($70,000
$28,000 ($70,000 -- $ 250,000 $ 250,000
Less expenses:
$42,000).
$42,000).
Salaries, insurance, etc. 150,000 150,000
Training program 40,000 -
Total expenses 190,000 150,000
Income before taxes 60,000 100,000
Less: income taxes (30%) 18,000 30,000
Net income $ 42,000 $ 70,000
The Concept of After-Tax Cost

The following formula shows the after-tax cost of any tax-deductible cash expense:

Tax-deductible
After-tax cost = (1 – Tax rate) ×
cash expense
= (1 – 0.30) × $40,000

= $28,000
The Concept of After-Tax Cost

The following formula shows the after-tax cost of any tax-deductible cash expense:

Tax-deductible
After-tax cost = (1 – Tax rate) ×
cash expense

The following formula shows the after-tax

benefit of any taxable cash receipt:

After-tax benefit = (1 – Tax rate) × Taxable

Cash receipt
The Concept of After-Tax Cost

North Company receives $80,000 per year

from subleasing part of its office space.
North is subject to a 30% tax rate.

What is the after-tax benefit

from the sublease?
The Concept of After-Tax Cost

North Company receives $80,000 per year

from subleasing part of its office space.
North is subject to a 30% tax rate.

What is the after-tax benefit

from the sublease?
After-tax benefit = (1 – Tax rate) × Taxable
Cash receipt
After-tax benefit = (1 – 0.30) × $80,000
= $56,000
The Concept of After-Tax Cost

South Company can invest in a project that

would provide cash receipts of $400,000 per
year. Cash operating expenses would be
$280,000 per year. The tax rate is 30%.

What is the after-tax benefit (net cash inflow)

each year from this project?
The Concept of After-Tax Cost

Annual
Annual cash
cash receipts
receipts $$400,000
400,000
Annual
Annual cash
cash operating
operating expenses
expenses 280,000
280,000
Annual
Annual net
net cash
cash inflow
inflow 120,000
120,000
Multiply
Multiply by
by (100%
(100% -- 30%)
30%) 70%
70%
Annual
Annual after-tax
after-tax net
net cash
cash inflows
inflows $$ 84,000
84,000
Capital Cost Allowance

• Capital cost allowance (CCA) is the

Canada Customs and Revenue Agency
(formerly Revenue Canada) counterpart to
amortization.
• For income tax purposes, amortization is
not an allowable deduction.
• Instead, CCA is permitted by regulations
that accompany the Canadian Income Tax
Act.
Capital Cost Allowance
• Capital cost allowance is determined by
asset pools, or classes, that have
prescribed rates.
• Capital cost allowance is calculated by
applying the prescribed rates to a declining
balance called undepreciated capital
cost (UCC). [Exception: Class 13]
• Net additions in each year are only allowed
a write-off of one-half of the prescribed rate
(called the half-year rule).
rule
Capital Cost Allowance

Calculate CCA for a Class 8 (20%) pool of

assets given the following:
UCC, Jan. 1, 2000 $25,000
Acquisitions during year 15,000
Disposals during year, cost 5,000
Proceeds from disposals 3,000

Let’s see how this works!

Capital Cost Allowance

UCC, Jan 1, 2000 $ 25,000

Acquisitions $ 15,000
Disposals (3,000)
Net additions 12,000
One-half of net additions 6,000
UCC for CCA purposes 31,000
CCA at 20% 6,200
24,800
Add back one-half of net additions 6,000
UCC, December 31, 2000 $ 30,800
Capital Cost Allowance

UCC, Jan 1, 2000 $ 25,000

Acquisitions $ 15,000
Disposals (3,000)
Net additions 12,000
One-half of net additions 6,000
UCC for CCA purposes 31,000
Disposals are
CCA at 20% 6,200
always recorded at 24,800
Add back one-half ofthe
netlesser of the
additions 6,000
UCC, December 31, proceeds
2000 or the $ 30,800
original capital cost
of the asset.
Tax Consequences of Asset Disposals
 If proceeds of disposal exceed the
UCC of the group of assets that
make up the asset class, previously
deducted CCA is recaptured.

If proceeds exceed the
 If all assets of a class have
been disposed of, any
original cost of the asset,
remaining balance in UCC
there will be a capital
is fully deductible as a
gain.
gain
terminal loss.
loss

Let’s try it!

Tax Consequences of Asset Disposals

Case
Case11 Case
Case22 Case
Case33 Case
Case44 Case
Case55
Beginning
BeginningUCC
UCC $$ 90,000
90,000 $$ 90,000
90,000 $$ 90,000
90,000 $$ 90,000
90,000 $$ 90,000
90,000
Disposal
Disposalofofassets
assets
Capital
Capitalcost
cost 42,500
42,500 93,000
93,000 120,000
120,000 120,000
120,000 120,000
120,000
Proceeds
Proceeds 20,000
20,000 98,000
98,000 100,000
100,000 55,000
55,000 140,000
140,000
Capital
Capitalgain
gain
UCC
UCCafter
afterdisposition
disposition
Recapture
Recapture
Terminal
TerminalLoss
Loss
Ending
EndingUCC
UCC

Note for this example that the Beginning UCC is

always $90,000 but that the information regarding
the disposal of assets varies.
Tax Consequences of Asset Disposals

Case
Case11 Case
Case22 Case
Case33 Case
Case44 Case
Case55
Beginning
BeginningUCC
UCC $$ 90,000
90,000 $$ 90,000
90,000 $$ 90,000
90,000 $$ 90,000
90,000 $$ 90,000
90,000
Disposal
Disposalofofassets
assets
Capital
Capitalcost
cost 42,500
42,500 93,000
93,000 120,000
120,000 120,000
120,000 120,000
120,000
Proceeds
Proceeds 20,000
20,000 98,000
98,000 100,000
100,000 55,000
55,000 140,000
140,000
Capital
Capitalgain
gain -0-
-0- 5,000
5,000 -0-
-0- -0-
-0- 20,000
20,000
UCC
UCCafter
afterdisposition
disposition
Recapture
Recapture
Terminal
TerminalLoss
Loss
Ending
EndingUCC
UCC
When Proceeds exceed Capital cost,
there is a capital gain on disposal.
Tax Consequences of Asset Disposals

Case
Case11 Case
Case22 CaseCase33 Case
Case44 CaseCase55
Beginning
BeginningUCC UCC $$90,000
90,000 $$ 90,000
90,000 $$90,000
90,000 $$ 90,000
90,000 $$90,000
90,000
Disposal
Disposalof
ofassets
assets
Capital
Capitalcost
cost 42,500
42,500 93,000
93,000 120,000
120,000 120,000
120,000 120,000
120,000
Proceeds
Proceeds 20,000
20,000 98,000
98,000 100,000
100,000 55,000
55,000 140,000
140,000
Capital
Capitalgain
gain -0-
-0- 5,000
5,000 -0-
-0- -0-
-0- 20,000
20,000
UCC
UCCafter
afterdisposition
disposition 70,000
70,000 (3,000)
(3,000) (10,000)
(10,000) 35,000
35,000 (30,000)
(30,000)
Recapture
Recapture
Terminal
TerminalLoss
Loss
Ending
EndingUCC
UCC

UCC after disposition = Beginning

UCC minus the lesser of proceeds or
original capital cost of disposed assets
Tax Consequences of Asset Disposals

Case
Case11 Case
Case22 CaseCase33 Case
Case44 Case
Case55
Beginning
BeginningUCC
UCC $$90,000
90,000 $$ 90,000
90,000 $$90,000
90,000 $$90,000
90,000 $$90,000
90,000
Disposal
Disposalofofassets
assets
Capital
Capitalcost
cost 42,500
42,500 93,000
93,000 120,000
120,000 120,000
120,000 120,000
120,000
Proceeds
Proceeds 20,000
20,000 98,000
98,000 100,000
100,000 55,000
55,000 140,000
140,000
Capital
Capitalgain
gain -0-
-0- 5,000
5,000 -0-
-0- -0-
-0- 20,000
20,000
UCC
UCCafter
afterdisposition
disposition 70,000
70,000 (3,000)
(3,000) (10,000)
(10,000) 35,000
35,000 (30,000)
(30,000)
Recapture
Recapture -0-
-0- (3,000)
(3,000) (10,000)
(10,000) -0-
-0- (30,000)
(30,000)
Terminal
TerminalLoss
Loss
Ending
EndingUCC
UCC

When UCC after disposition is negative,

that negative amount represents
recaptured CCA and is included in
calculating taxable income for the year.
Tax Consequences of Asset Disposals

Case
Case11 Case
Case22 CaseCase33 Case
Case44 CaseCase55
Beginning
BeginningUCC
UCC $$90,000
90,000 $$ 90,000
90,000 $$90,000
90,000 $$ 90,000
90,000 $$90,000
90,000
Disposal
Disposalof
ofassets
assets
Capital
Capitalcost
cost 42,500
42,500 93,000
93,000 120,000
120,000 120,000
120,000 120,000
120,000
Proceeds
Proceeds 20,000
20,000 98,000
98,000 100,000
100,000 55,000
55,000 140,000
140,000
Capital
Capitalgain
gain -0-
-0- 5,000
5,000 -0-
-0- -0-
-0- 20,000
20,000
UCC
UCCafter
afterdisposition
disposition 70,000
70,000 (3,000)
(3,000) (10,000)
(10,000) 35,000
35,000 (30,000)
(30,000)
Recapture
Recapture -0-
-0- (3,000)
(3,000) (10,000)
(10,000) -0-
-0- (30,000)
(30,000)
Terminal
TerminalLoss
Loss -0-
-0- -0-
-0- -0-
-0- 35,000
35,000 -0-
-0-
Ending
EndingUCC
UCC

A terminal loss arises when there is a balance

remaining in the UCC after disposition but no assets
remain in the asset pool, as shown in Case 4. This
amount is fully deductible in calculating taxable income.
Tax Consequences of Asset Disposals

Case
Case11 Case
Case22 Case
Case33 Case
Case44 Case
Case55
Beginning
BeginningUCC
UCC $$ 90,000
90,000 $$ 90,000
90,000 $$ 90,000
90,000 $$ 90,000
90,000 $$ 90,000
90,000
Disposal
Disposalofofassets
assets
Capital
Capitalcost
cost 42,500
42,500 93,000
93,000 120,000
120,000 120,000
120,000 120,000
120,000
Proceeds
Proceeds 20,000
20,000 98,000
98,000 100,000
100,000 55,000
55,000 140,000
140,000
Capital
Capitalgain
gain -0-
-0- 5,000
5,000 -0-
-0- -0-
-0- 20,000
20,000
UCC
UCCafter
afterdisposition
disposition 70,000
70,000 (3,000)
(3,000) (10,000)
(10,000) 35,000
35,000 (30,000)
(30,000)
Recapture
Recapture -0-
-0- (3,000)
(3,000) (10,000)
(10,000) -0-
-0- (30,000)
(30,000)
Terminal
TerminalLoss
Loss -0-
-0- -0-
-0- -0-
-0- 35,000
35,000 -0-
-0-
Ending
EndingUCCUCC 70,000
70,000 -0-
-0- -0-
-0- -0-
-0- -0-
-0-

Ending UCC will have a balance so long

as there are assets remaining in the pool
and there has been no recapture of CCA.
Capital Cost Allowance Tax Shield

Although capital cost allowance (CCA) is not a

cash flow, it does have an impact on the
amount of income taxes that a company will
pay. CCA deductions shield revenues from
taxation and thereby reduce tax payments.

Let’s look at an example of a

capital cost allowance
tax shield.
Capital Cost Allowance Tax Shield

Art
Art and
and Music
Music Companies
Companies are
are identical
identical except
except that
that Art
Art has
has aa
$60,000
$60,000 annual
annual amortization
amortization expense
expense (=CCA
(=CCA deduction):
deduction):
Art Music
Company Company
Sales $ 500,000 $ 500,000
Less expenses:
Cash operating expenses 340,000 340,000
Amortization expense 60,000 -
Total expenses 400,000 340,000
Income before taxes 100,000 160,000
Less income taxes (30%) 30,000 48,000
Net income $ 70,000 $ 112,000
Capital Cost Allowance Tax Shield

As
As aa result
result of
of the
the CCA
CCA deduction,
deduction, Art
Art has
has less
less net
net
income
income than
than Music.
Music. But
But the
the difference
difference is
is not
not $60,000.
$60,000.
Art Music
Company Company
Sales $ 500,000 $ 500,000
Less expenses:
Cash operating expenses 340,000 340,000
Amortization expense 60,000 -
Total expenses 400,000 340,000
Income before taxes 100,000 160,000
Less income taxes (30%) 30,000 48,000
Net income $ 70,000 $ 112,000
Capital Cost Allowance Tax Shield

Let’s look more closely at the difference in

net income.

Net
Net income
income of
of Music
Music $$112,000
112,000
Net
Net income
income of
of Art
Art 70,000
70,000
Difference
Difference in
in net
net income
income 42,000
42,000

We can compute the difference in net income

as follows:
$60,000 × (1 – 0.30) = $42,000
Capital Cost Allowance Tax Shield

The tax savings provided by the capital cost

allowance tax shield is determined like this:
CCA Tax CCA
= ×
Tax Shield rate deduction

= 0.30 × $60,000 = $18,000

Amortization $60,000
Less: tax savings 18,000
Difference in income $42,000
CCA Tax Shield Formula

Cdt 1 + 0.5k
PV = d+k
x 1+k
Where,
PV = Present Value

C = capital cost of the asset added to the asset pool

d = CCA rate
t = marginal income tax rate
k = cost of capital
CCA Tax Shield Formula

Cdt 1 + 0.5k
PV = d+k
x 1+k
Where
Represents correction
C = capital costto
factor of account
the asset added to pool
for half-
year rule during year of
d = CCA rate
acquisition.
t = marginal income tax rate
k = cost of capital
CCA Tax Shield Formula
The Tax shield is
adjusted by Sdt
deducting the
PV of the
d+k
x (1 + k) -n
salvage value

Where
S = salvage value of the asset added to the pool
d = CCA rate
t = marginal income tax rate
k = cost of capital
n = useful life of asset Let’s see how this works!
Capital Budgeting and Taxes

Martin Company has an investment opportunity

that would involve the following cash flows:

Co s t o f ne w e quipme nt $ 4 00 ,00 0
Wo rking c a pital re quire d 8 0 ,0 0 0
Ne t annual c a s h re c e ipts for 8 ye a rs 1 00 ,00 0
Equipme nt re pa irs in 4 ye a rs 4 0 ,0 0 0
Salva g e value o f e quipme nt 5 0 ,0 0 0
Capital Budgeting and Taxes

• The equipment has an estimated useful life of

8 years.
• For tax purposes the equipment is a Class 8
asset with a 20% prescribed rate.
• Martin has an after-tax cost of capital of 10%
and is subject to a 30% income tax rate.

Should Martin invest in this project?

Capital Budgeting and Taxes
After-Tax
After-Tax 10%
10% Present
Present
Flows
Flows Years
Years Amount Tax Effect Cash Flows
Amount Tax Effect Cash Flows Factor
Factor Value
Value
Cost
Costofofnew
newequipment
equipment Now
Now (400,000)
(400,000) - - (400,000)
(400,000) 1.000
1.000 (400,000)
(400,000)
Working
Working capitalneeded
capital needed Now
Now (80,000)
(80,000) - - (80,000)
(80,000) 1.000
1.000 (80,000)
(80,000)
Net annual cash receipts
Net annual cash receipts
Equipment
Equipmentrepairs
repairs
Salvage
Salvage valueofofequipment
value equipment
Release
Release of workingcapital
of working capital
Subtotal
Subtotal
Present
Presentvalue
valueofofCCA
CCAtax
taxshield:
shield: Start with current needs
in today’s dollars
Net
Netpresent
presentvalue
value
Capital Budgeting and Taxes
After-Tax
After-Tax 10%
10% Present
Present
Flows
Flows Years
Years Amount Tax Effect Cash Flows
Amount Tax Effect Cash Flows Factor
Factor Value
Value
Cost
Costofofnew
newequipment
equipment Now
Now (400,000)
(400,000) - - (400,000)
(400,000) 1.000
1.000 (400,000)
(400,000)
Working
Working capitalneeded
capital needed Now
Now (80,000)
(80,000) - - (80,000)
(80,000) 1.000
1.000 (80,000)
(80,000)
Net annual cash receipts
Net annual cash receipts 1-1-88 100,000
100,000 0.70
0.70 70,000
70,000 5.335
5.335 373,450
373,450
Equipment
Equipmentrepairs
repairs
Salvage
Salvage valueofofequipment
value equipment
Release
Release of workingcapital
of working capital
Subtotal
Subtotal
Present
Presentvalue
valueofofCCA
CCAtax
taxshield:
shield:

Net
Netpresent
Number of years of
presentvalue
value
PV of an annuity
cash flows @10% for 8 years

1 minus the tax rate

(1 - 0.30) = 0.70
Capital Budgeting and Taxes
After-Tax
After-Tax 10%
10% Present
Present
Flows
Flows Years
Years Amount Tax Effect Cash Flows
Amount Tax Effect Cash Flows Factor
Factor Value
Value
Cost
Costofofnew
newequipment
equipment Now
Now (400,000)
(400,000) - - (400,000)
(400,000) 1.000
1.000 (400,000)
(400,000)
Working
Working capitalneeded
capital needed Now
Now (80,000)
(80,000) - - (80,000)
(80,000) 1.000
1.000 (80,000)
(80,000)
Net annual cash receipts
Net annual cash receipts 1-1-88 100,000
100,000 0.70
0.70 70,000
70,000 5.335
5.335 373,450
373,450
Equipment
Equipmentrepairs
repairs 44 (40,000)
(40,000) 0.70
0.70 (28,000)
(28,000) 0.683
0.683 (19,124)
(19,124)
Salvage
Salvage valueofofequipment
value equipment
Release
Release of workingcapital
of working capital
Subtotal
Subtotal
Present
Presentvalue
valueofofCCA
CCAtax
taxshield:
shield:

Net
Netpresent
presentvalue
Number of years until
value PV of $1 at 10%
repair required after four years

1 minus the tax rate

(1 - 0.30) = 0.70
Capital Budgeting and Taxes
After-Tax
After-Tax 10%
10% Present
Present
Flows
Flows Years
Years Amount Tax Effect Cash Flows
Amount Tax Effect Cash Flows Factor
Factor Value
Value
Cost
Costofofnew
newequipment
equipment Now
Now (400,000)
(400,000) - - (400,000)
(400,000) 1.000
1.000 (400,000)
(400,000)
Working
Working capitalneeded
capital needed Now
Now (80,000)
(80,000) - - (80,000)
(80,000) 1.000
1.000 (80,000)
(80,000)
Net annual cash receipts
Net annual cash receipts 1-1-88 100,000
100,000 1-0.30
1-0.30 70,000
70,000 5.335
5.335 373,450
373,450
Equipment
Equipmentrepairs
repairs 44 (40,000) 1-0.30
(40,000) 1-0.30 (28,000)
(28,000) 0.683
0.683 (19,124)
(19,124)
Salvage
Salvage valueofofequipment
value equipment 88 50,000
50,000 - - 50,000
50,000 0.467
0.467 23,350
23,350
Release
Release of workingcapital
of working capital 88 80,000
80,000 - - 80,000
80,000 0.467
0.467 37,360
37,360
Subtotal
Subtotal (64,964)
(64,964)
Present
Presentvalue
valueofofCCA
CCAtax
taxshield:
shield:

Net
Netpresent
presentvalue
value

Don’t forget, salvage value PV of $1 at 10%

of equipment and release after eight years
of working capital at end of
eight year
Capital Budgeting and Taxes
After-Tax
After-Tax 10%
10% Present
Present
Flows
Flows Years
Years Amount Tax Effect Cash Flows
Amount Tax Effect Cash Flows Factor
Factor Value
Value
Cost of new equipment
Cost of new equipment Now
Now (400,000)
(400,000) - - (400,000)
(400,000) 1.000
1.000 (400,000)
(400,000)
Working capital needed
Working capital needed Now
Now (80,000)
(80,000) - - (80,000)
(80,000) 1.000
1.000 (80,000)
(80,000)
Net annual cash receipts
Net annual cash receipts 1-
1-88 100,000
100,000 1-0.30
1-0.30 70,000
70,000 5.335
5.335 373,450
373,450
Equipment
Equipmentrepairs
repairs 44 (40,000) 1-0.30
(40,000) 1-0.30 (28,000)
(28,000) 0.683
0.683 (19,124)
(19,124)
Salvage
Salvagevalue
valueofofequipment
equipment 88 50,000
50,000 - - 50,000
50,000 0.467
0.467 23,350
23,350
Release
Releaseofofworking
workingcapital
capital 88 80,000
80,000 - - 80,000
80,000 0.467
0.467 37,360
37,360
Subtotal
Subtotal (64,964)
(64,964)
Present
Presentvalue
valueofofCCA
CCAtax
taxshield:
shield:
PV=
PV=400,000
400,000xx.2.2xx.3.3
.2.2++.10
.10
xx 1.05
1.10
1.10
{
1.05 - - 50,000
50,000xx.2.2xx.3.3
.2.2++.10
.10
xx (1(1++.10)
}
-8
.10) -8

Net
Netpresent
presentvalue
value

Finally, calculate the PV

of the CCA tax shield
adjusted for the salvage
value at end of eight year
Capital Budgeting and Taxes
After-Tax
After-Tax 10%
10% Present
Present
Flows
Flows Years
Years Amount Tax Effect Cash Flows
Amount Tax Effect Cash Flows Factor
Factor Value
Value
Cost of new equipment
Cost of new equipment Now
Now (400,000)
(400,000) - - (400,000)
(400,000) 1.000
1.000 (400,000)
(400,000)
Working capital needed
Working capital needed Now
Now (80,000)
(80,000) - - (80,000)
(80,000) 1.000
1.000 (80,000)
(80,000)
Net annual cash receipts
Net annual cash receipts 1-
1-88 100,000
100,000 1-0.30
1-0.30 70,000
70,000 5.335
5.335 373,450
373,450
Equipment
Equipmentrepairs
repairs 44 (40,000) 1-0.30
(40,000) 1-0.30 (28,000)
(28,000) 0.683
0.683 (19,124)
(19,124)
Salvage
Salvagevalue
valueofofequipment
equipment 88 50,000
50,000 - - 50,000
50,000 0.467
0.467 23,350
23,350
Release
Releaseofofworking
workingcapital
capital 88 80,000
80,000 - - 80,000
80,000 0.467
0.467 37,360
37,360
Subtotal
Subtotal (64,964)
(64,964)
Present
Presentvalue
valueofofCCA
CCAtax
taxshield:
shield:
-8
PV=
PV=400,000
400,000xx.2.2xx.3.3 xx 1.05
1.05 - - 50,000
50,000xx.2.2xx.3.3 xx (1(1++.10)
.10) -8
.2.2++.10
.10 1.10
1.10 .2.2++.10
.10
==80,000 x 0.955 -
80,000 x 0.955 - (10,000 (10,000 x 0.463)
x 0.463) 71,734
71,734
Net present value
Net present value

Finally, calculate the PV of the

CCA tax shield adjusted for the
salvage value at end of eight year
Capital Budgeting and Taxes
After-Tax
After-Tax 10%
10% Present
Present
Flows
Flows Years
Years Amount Tax Effect Cash Flows
Amount Tax Effect Cash Flows Factor
Factor Value
Value
Cost of new equipment
Cost of new equipment Now
Now (400,000)
(400,000) - - (400,000)
(400,000) 1.000
1.000 (400,000)
(400,000)
Working capital needed
Working capital needed Now
Now (80,000)
(80,000) - - (80,000)
(80,000) 1.000
1.000 (80,000)
(80,000)
Net annual cash receipts
Net annual cash receipts 1-
1-88 100,000
100,000 1-0.30
1-0.30 70,000
70,000 5.335
5.335 373,450
373,450
Equipment
Equipmentrepairs
repairs 44 (40,000) 1-0.30
(40,000) 1-0.30 (28,000)
(28,000) 0.683
0.683 (19,124)
(19,124)
Salvage
Salvagevalue
valueofofequipment
equipment 88 50,000
50,000 - - 50,000
50,000 0.467
0.467 23,350
23,350
Release
Releaseofofworking
workingcapital
capital 88 80,000
80,000 - - 80,000
80,000 0.467
0.467 37,360
37,360
Subtotal
Subtotal (64,964)
(64,964)
Present
Presentvalue
valueofofCCA
CCAtax
taxshield:
shield:
-8
PV=
PV=400,000
400,000xx.2.2xx.3.3 xx 1.05
1.05 - - 50,000
50,000xx.2.2xx.3.3 xx (1(1++.10)
.10) -8
.2.2++.10
.10 1.10
1.10 .2.2++.10
.10
==80,000 x 0.955 -
80,000 x 0.955 - (10,000 (10,000 x 0.463)
x 0.463) 71,734
71,734
Net present value
Net present value 6,770
6,770

Since the net present value is

positive, the Martin Company
should buy the equipment
Risk and Uncertainty
in Capital Budgeting
A Statistical Measure of Risk

Standard Deviation measures the extent actual

returns deviate from expected returns.
Coefficient of Variation (CV) measures the
relative risk of an investment project.
Correlation is a statistical technique that
measures the relationship of the returns of the
project to those of another.
Sensitivity Analysis provides management with
insight into the effects of changes in variables such
as cash flow estimates and discount rates.
End of Presentation