Lecture 2 Ch9

Chapter Outline
9.1 The Capital Budgeting Process

9.2 Forecasting Incremental Earnings
9.3 Determining Incremental Free Cash Flow
9.4 Other Effects on Incremental Free Cash Flows
9.5 Analyzing the Project
9.6 Real Options in Capital Budgeting
Copyright © 2023 Pearson Canada Inc. 9-1

9.1 The Capital Budgeting Process
• Capital Budget: A list of the projects that a company
plans to undertake during the next period.
• Capital Budgeting: The process of analyzing
investment opportunities and deciding which ones to
accept.
• Incremental Earnings: The amount by which a firm’s
earnings are expected to change as a result of an
investment decision.

(1 of 9)
• Incremental Revenue and Cost Estimates

– Factors to consider when estimating a project’s
revenues and costs:
1. A new product typically has lower sales initially
2. The average selling price of a product and its cost of
production will generally change over time
3. For most industries, competition tends to reduce profit
margins over time

(2 of 9)
• Operating Expenses Versus Capital Expenditures

– Operating Expenses
– Capital Expenditures

(3 of 9)
• Capital Expenses and Capital Cost Allowance

– The cost of plant, property, and equipment is divided
to be deducted when estimating earnings.
▪ For tax purposes, the Canada Revenue Agency requires
the use of Capital Cost Allowance (CCA).
▪ For financial purposes, CCA is not usually used.

(4 of 9)
• Capital Budgeting with First-Year Half-Year Rule: CRA

assumes assets qualify for half a year’s worth of CCA
in the first tax year. Thus, when an asset is
purchased, one-half of its cost, denoted as CapEx, is
added to the undepreciated capital cost (UCC) for the
asset pool in the same class.
• We denote this addition to the UCC as UCC1. Thus
UCC1 = 0.5 × CapEx.

(5 of 9)
• Capital Budgeting with Straight Line Depreciation:

the depreciation amount is equal for each accounting
period of an asset’s useful life; used under certain
circumstances.
• For more information see the link on the CRA website
about Accelerated Investment Incentive as follows:
https://www.canada.ca/en/revenue-agency/services/ta
x/businesses/topics/sole-proprietorships-partnerships/
report-business-income-expenses/claiming-capital-co
st-allowance/accelerated-investment-incentive.html

(6 of 9)
• The incremental CCA deduction claimed at the end of

the tax year is undepreciated capital cost multiplied
by the CCA rate:
• The incremental UCC is calculated as:

(7 of 9)
• Incremental Revenue and Cost Estimates

Key Terms and Definitions (1 of 2)
• Capital cost allowance (CCA): The Canada
Revenue Agency method of depreciation for income
tax purposes.
• CCA rate: The proportion of undepreciated capital
cost that can be claimed as CCA in a given tax year.
Copyright © 2023 Pearson Canada Inc. 9 - 10

Key Terms and Definitions (2 of 2)
• Half-year rule: A rule stating that, as assets may be
purchased at any time throughout a year, it can be
assumed that on average an asset is owned for half a
year during the first tax year of its ownership.
• Undepreciated Capital Cost (UCC): The balance, at
a point in time, calculated by deducting an asset’s
current and prior CCA amounts from the original cost
of the asset.

(8 of 9)
• Taxes
– Marginal Corporate Tax Rate
▪ The tax rate a firm will pay on an incremental dollar of
pre-tax income

Example 9.1: Taxing Losses for
Projects in Profitable Companies (1 of 2)
• Loblaw Companies Ltd. plans to launch a new line of
high-fibre, zero-trans-fat breakfast pastries. The heavy
advertising expenses associated with the new product
launch will generate operating losses of $15 million
next year for the product.

Projects in Profitable Companies (2 of 2)
• Loblaw expects to earn pre-tax income of
$460 million from operations other than the new
pastries next year. If Loblaw pays a 40% tax rate on
its pre-tax income, what will it owe in taxes next year
without the new pastry product? What will it owe with
the new product?

Projects in Profitable Companies: Plan
• We need Loblaw’s pre-tax income with and without
the new product losses and its tax rate of 40%. We
can then compute the tax without the losses and
compare it to the tax with the losses.

Example 9.1: Taxing Losses for Projects in
Profitable Companies: Execute
• Without the new product, Loblaw will owe
$460 million × 40% = $184 million in corporate taxes
next year. With the new product, Loblaw’s pre-tax
income next year will be only
$460 million − $15 million = $445 million, and it will
owe $445 million × 40% = $178 million in tax.

Example 9.1: Taxing Losses for Projects in
Profitable Companies: Evaluate
• Thus, launching the new product reduces Loblaw’s
taxes next year by $184 million − $178 million = $6
million. Because the losses on the new product
reduce Loblaw’s taxable income dollar for dollar, it is
the same as if the new product had a tax bill of
negative $6 million.

(9 of 9)
• Incremental Earnings Forecast

– Pro Forma Statement: A statement that is not based
on actual data but rather depicts a firm’s financials
under a given set of hypothetical assumptions.
– Taxes and Negative EBIT
– Interest Expense
▪ Unlevered Net Income: Net income that does not
include

9.3 Determining Incremental Free Cash
Flow (1 of 5)
• Calculating Free Cash Flow from Earnings
– Free Cash Flow
▪ The incremental effect of a project on a firm’s available
cash
– Capital Expenditures and Capital Cost Allowance

Example 9.2: Incremental Free Cash
Flows
• Let’s consider the SPI Phone 86 example. In
Table 9.2, we computed the incremental
earnings for the SPI Phone 86, but we need
the incremental free cash flows to decide whether SPI
should proceed with the project.

Flows: Plan
• The difference between the incremental earnings and
incremental free cash flows in the SPI Phone 86
example will be driven by the equipment purchased for
the lab. We need to recognize the $7.5 million cash
outflow associated with the purchase in year 0 and
add back the CCA deductions from years 1 to 5, as
they are not actually cash outflows.

Flows: Execute
Year Blank 0 1 2 3 4 5
Incremental Blank Blank Blank Blank Blank Blank Blank

Earnings Forecasts
1 Sales - 26,000 26,000 26,000 26,000 -
2 Cost of Goods Sold - (11,000) (11,000) (11,000) (11,000) -
3 Gross Profit - 15,000 15,000 15,000 15,000 -
4 S&G expenses - (2,800) (2,800) (2,800) (2,800) -
5 R&D (15,000) - - - - -
6 Capital Cost Allowance - (1,688) (2,616) (1,439) (791) (435)
7 EBIT (15,000) 10,513 9,584 10,761 11,409 (435)
8 Income Tax @ 40% 6,000 (4,205) (3,834) (4,305) (4,564) 174
9 Unlevered NI (9,000) 6,308 5,751 6,457 6,845 (261)
10 Plus: CCA - 1,688 2,616 1,439 791 435
11 Less: Capital Expenditure (7,500) Blank Blank Blank Blank Blank
13 Free Cash Flows (16,500) 7,995 8,366 7,895 7,636 174

Flows: Evaluate
• By recognizing the outflow from purchasing the
equipment in year 0, we account for the fact that $7.5
million left the firm at that time. By adding back the
CCA deductions in years 1 to 5, we adjust the
incremental earnings to reflect the fact that CCA
deductions are not cash outflows.

Flow (2 of 5)
• Calculating Free Cash Flow from Earnings
– Net Working Capital
▪ Trade Credit
– The difference between receivables and payables is the
net amount of the firm’s capital that is consumed as a
result of these credit transactions

Example 9.3: Incorporating Changes in
Net Working Capital (1 of 2)
• Suppose that the SPI Phone 86 will have no
incremental cash or inventory requirements (products
will be shipped directly from the contract manufacturer
to customers). However, receivables related to the SPI
Phone 86 are expected to account for 15% of annual
sales, and payables are expected to be 15% of the
annual cost of goods sold (COGS). Fifteen percent of
$26 million in sales is $3.9 million, and 15% of $11
million in COGS is $1.65 million. SPI Phone 86’s NWC
requirements are shown in the following table:

Net Working Capital (2 of 2)
1 Year 0 1 2 3 4 5
2 Net Working Capital Forecast (000s) Blank Blank Blank Blank Blank 0
3 Cash Requirement 0 0 Blank Blank Blank 0
4 Inventory 0 0 Blank Blank Blank 0
5 Receivables (15% of sales) 0 3,900 3,900 3,900 3,900 0
6 Payables (15% of COGS) 0 −1650 −1650 −1650 −1650 0
7 Net Working Capital 0 2,250 2,250 2,250 2,250 0

Net Working Capital: Plan (1 of 3)
• Any increases in NWC represent an investment that
reduces the cash available to the firm and so reduces
free cash flow. We can use our forecast of the SPI
Phone 86’s NWC requirements to complete our
estimate of SPI Phone 86’s free cash flow.

• This increase represents a cost to the firm. This
reduction of free cash flow corresponds to the fact that
$3.900 million of the firm’s sales in year 1, and $1.625
million of its costs, have not yet been paid.

• In years 2 to 4, NWC does not change, so no further
contributions are needed. In year 5, when the project
is shut down, NWC falls by $2.250 million as the
payments of the last customers are received and the
final bills are paid. We add this $2.250 million to free
cash flow in year 5.

Net Working Capital: Execute (1 of 2)
• Cash flow requirements are:
1 Year 0 1 2 3 4 5
2 Net Working Capital 0 2,250 2,250 2,250 2,250 0
3 Change in NWC Blank +2,250 0 0 0 −2,500
4 Cash Flow Effect Blank −2,250 0 0 0 +2,500

Net Working Capital: Execute (2 of 2)
• The incremental free cash flows would then be:
Incremental Earnings Blank Blank Blank Blank Blank Blank Blank
Forecasts
1 Sales ̶ 26,000 26,000 26,000 26,000 ̶
2 Cost of Goods Sold ̶ (11,000) (11,000) (11,000) (11,000) ̶
3 Gross Profit ̶ 15,000 15,000 15,000 15,000 ̶
4 S&G expenses ̶ (2,800) (2,800) (2,800) (2,800) ̶
5 R&D (15,000) ̶ ̶ ̶ ̶ ̶
6 Capital Cost Allowance ̶ (1,688) (2,616) (1,439) (791) (435)
7 EBIT (15,000) 10,513 9,584 10,761 11,409 (435)
8 Income Tax @ 40% 6,000 (4,205) (3,834) (4,305) (4,564) 174
9 Unlevered NI (9,000) 6,308 5,751 6,457 6,845 (261)
10 Plus: CCA ̶ 1,688 2,616 1,439 791 435
11 Less: Capital Expenditure (7,500) Blank Blank Blank Blank Blank
Blank Less: Increase in NWC ̶ −2,250 ̶ ̶ ̶ 2,250
13 Free Cash Flows (16,500) 5,995 8,366 7,895 7,636 2,424

Net Working Capital: Evaluate (1 of 2)
• The free cash flows differ from unlevered net income
by reflecting the cash flow effects of capital
expenditures on equipment, CCA, and changes in
NWC. Note that in the first two years, free cash flow is
lower than unlevered net income, reflecting the
upfront investment in equipment and NWC required
by the project.

Net Working Capital: Evaluate (2 of 2)
• In later years, free cash flow exceeds unlevered net
income because depreciation is not a cash expense.
In the last year, the firm ultimately recovers the
investment in NWC, further boosting the free cash
flow.

Flow (3 of 5)
• Calculating Free Cash Flow Directly
(9.8)
(9.9)

Flow (4 of 5)
• Calculating Free Cash Flow Directly
– CCA tax shield: The tax savings that results from the
ability to deduct depreciation.

Flow (5 of 5)
• Calculating the NPV
– To compute a project’s NPV, one must discount its
free cash flow at the appropriate cost of capital

Example 9.4: Calculating the Project’s
NPV
• Assume that SPI’s managers believe that the SPI
Phone 86 project has risks similar to those of SPI’s
existing projects, for which it has a cost of capital of
12%. Compute the NPV of the SPI Phone 86 project.

NPV: Plan
• From Example 9.3, the incremental free cash flows for
the SPI Phone 86 project are (in $000s):
1 Year 0 1 2 3 4 5
2 Incremental Free Cash Flow (16,500) 5,745 8,366 7,895 7,636 2,424
• To compute the NPV, we sum the present values of all

of the cash flows, noting that the year 0 cash outflow
is already a present value.

NPV: Execute
• Using Eq. 9.10:

NPV: Evaluate
• Based on our estimates, the SPI Phone 86’s NPV is
$7.147 million. While the SPI Phone 86’s upfront cost
is $16.5 million, the present value of the additional
free cash flow that SPI will receive from the project is
$23.647 million. Thus, taking the SPI Phone 86
project is equivalent to SPI having an extra $7.147
million in the bank today.

9.4 Other Effects on Incremental Free
Cash Flows (1 of 7)
• Opportunity Costs: the value a resource could have
provided in its best alternative use.
• Project Externalities: Indirect effects of a project that
may increase or decrease the profits of other business
activities of a firm.
– Cannibalization: The displacement of the sales of one
of a firm’s existing products by the sales of the firm’s
new product.

Cash Flows (2 of 7)
• Sunk Costs: Any unrecoverable cost for which a firm
is already liable.
– Fixed Overhead Expenses
– Past Research for Feasibility
▪ E.g., SPI paid $2000 for a research study analyzing
the effects: Sunk cost
▪ Sunk cost is not considered in evaluating a project, so
just ignore it!

Cash Flows (3 of 7)
• Adjusting Free Cash Flow
– Timing of Cash Flows
– Perpetual CCA Tax Shields

Cash Flows (4 of 7)
– Liquidation or salvage value
▪ Capital gain tax: A tax collected on the profit (the amount by
which the sale price exceeds the original purchase price)
from assets in the year in which the assets are sold.

Cash Flows (5 of 7)
– Continuing Pool, Negative Net Additions:
▪ The present value of the reduction in CCA tax shields
can be calculated as follows:

Example 9.5: Adding Salvage Value and
CCA Effects to the Analysis (1 of 2)
• SPI is expected to sell the specialized computer
equipment at date 4 (or the beginning of tax
year 5), as the lab will be shut down at that point. The
expected Sale Price is high, $8 million, because of the
expected appreciation of precious minerals used
within the computer equipment.

CCA Effects to the Analysis (2 of 2)
• It is expected that SPI will still own other computer
equipment at that time but will not be making such
purchases in excess of $8 million in tax year 5. Redo
the NPV calculation for the SPI Phone 86 project,
given this new information.

CCA Effects to the Analysis: Plan
• In order to compute the after-tax cash flow, you will
need to incorporate the effects on cash flows of the
salvage value, the capital gains tax (using Equation
9.13), and the lost CCA tax shields (using Equation
9.16).

CCA Effects to the Analysis: Execute (1 of 2)
Incremental Blank Blank Blank Blank Blank Blank Blank

Earnings Forecasts
1 Sales - 26,000 26,000 26,000 26,000 -
2 Cost of Goods Sold - (11,000) (11,000) (11,000) (11,000) -
3 Gross Profit - 15,000 15,000 15,000 15,000 -
4 S&G expenses - (2,800) (2,800) (2,800) (2,800) -
5 R&D (15,000) - - - - -
6 Capital Cost not included, as analyzed separately

Allowance
7 EBIT (15,000) 12,200 12,200 12,200 12,200 -
8 Income Tax @ 40% 6,000 (4,800) (4,800) (4,800) (4,800) -
9 Unlevered NI (9,000) 7,320 7,320 7,320 7,320 -
Free Cash Flows

CCA Effects to the Analysis: Execute (2 of 2)
10 Plus: CCA not included, as analyzed separately
11 Less: Net Capital (7,500) Blank Blank Blank Blank Blank

Expenditure
Blank Less: Increase in - −2,250 - - - 2,250
NWC
13 Less Capital Gain Blank Blank Blank Blank Blank (100)
tax
14 FCF (excl. Tax (16,500) 5,070 7,320 7,320 15,320 2,150
shield)
15 Project cost of 12% Blank Blank Blank Blank Blank
capital
16 Discount Factor 1.00 .8929 .7972 .7118 .6355 .5674
17 PV of FCF (excl. (16,500) 4,527 5,835 5,210 9,736 1,220

Tax shield)
18 PV of CCA tax 736 Blank Blank Blank Blank Blank
shields
19 NPV 10,765 Blank Blank Blank Blank Blank

NPV Calculation
•

CCA Effects to the Analysis: Evaluate
• You should notice that the NPV is much higher than
what was calculated in the Table 9.6 spreadsheet. The
reason it is higher is because of the large asset sale
price. Also note that the PV of CCA tax shields is
lower and there is a capital gain; these are the other
effects of the asset sale.

Cash Flows (6 of 7)
– Tax Loss Carryforwards/Tax Loss Carrybacks: A
tax collected on the profit (the amount by which the
sale price exceeds the original purchase price)
from assets in the year in which the assets are sold.

Cash Flows (7 of 7)
• Replacement Decisions
– Often the financial manager must decide whether to
replace an existing piece of equipment
▪ The new equipment may allow increased production,
resulting in incremental revenue, or it may simply be
more efficient, lowering costs.

Example 9.6: Replacing an Existing
Machine (1 of 2)
• You are trying to decide whether to replace a machine
on your production line. The new machine will cost
$1.25 million but will be more efficient than the old
machine, reducing costs by $500,000 per year. Your
old machine could be sold for $50,000. You expect to
sell the new machine for $100,000 after five years.

Machine (2 of 2)
• While the company does not intend to add any more
assets into the pool in five years, it does have many
assets in the pool, so the pool will continue
indefinitely. The new machine will not change your
working capital needs. The CCA rate is 45%. The tax
rate is 40% and the firm expects a 12% return on this
project.

Machine: Plan
• Incremental revenues: 0
• Incremental costs: −$500,000 (a reduction in costs will
appear as a positive number in the costs line of our
analysis)
• Incremental capital expenditure:
$1.25 million − $50,000 = $1.2 million.
This is the net change to the asset pool
upon replacement.
• Cash flow from salvage value: +$100,000

Machine: Execute (1 of 2)
Incremental Earnings Blank Blank Blank Blank Blank Blank Blank

Forecasts (000s)
1 Sales - - - - - -
2 Cost of Goods - 500,000 500,000 500,000 500,000 500,000

Sold
3 Gross Profit - 500,000 500,000 500,000 500,000 500,000
4 Capital Cost not included as analyzed separately

Allowance
7 EBIT - 500,000 500,000 500,000 500,000 500,000
8 Income Tax @ - (200,000) (200,000) (200,000) (200,000) (200,000)

40%
9 Unlevered NI - 300,000 300,000 300,000 300,000 300,000
10 Free Cash Flow

(including CCA Tax
Shield)

Machine: Execute (2 of 2)
10 Plus: CCA not included as analyzed separately
11 Less: Net Capital (1,200,000) Blank Blank Blank Blank 100,000

Expenditure
14 FCF (excl. Tax (1,200,000) 300,000 300,000 300,000 300,000 400,000
shield)
15 Project cost of 12% Blank Blank Blank Blank Blank
capital
16 Discount Factor 1.00 0.8929 0.7972 0.7118 0.6355 0.5674
17 PV of FCF (excl. (1,200,000) 267,857 239,158 213,534 190,655 226,971

Tax shield)
18 PV of CCA tax 338,578 Blank Blank Blank Blank Blank
shields
19 NPV 276,753 Blank Blank Blank Blank Blank

Machine: Evaluate (1 of 2)
• Even though the decision has no impact on revenues,
it still matters for cash flows because it reduces costs.
Just as important are the tax implications of both
selling the old machine and buying the new machine.

Machine: Evaluate (2 of 2)
• Notice that the PV of the CCA tax shields is greater
than the NPV. Had we not considered these tax
implications, the replacement opportunity would not
have looked like a good one.

9.5 Analyzing the Project (1 of 4)
• Sensitivity Analysis
– A capital budgeting tool that shows how the NPV
varies as a single underlying assumption is changed.

• Break-Even Analysis
– Break-Even
▪ The level of a parameter for which an investment has an
NPV of zero.

• Break-Even Analysis
– Accounting Break-Even
▪ EBIT Break-Even
– The level of a particular parameter for which a project’s
EBIT is zero
Units Sold × (Sale Price − Cost per Unit) − SG&A − CCA = 0

• Scenario Analysis
– A capital budgeting tool that shows how the NPV
varies as a number of the underlying assumptions
are changed simultaneously

9.6 Real Options in Capital Budgeting
• Real Option: The right, but not the obligation, to take
a particular business action
• Option to Delay: option to time a particular
investment, which is almost always present.
• Option to Expand: option to start with limited
production and expand only if the project is
successful.
• Option to Abandon: option for an investor to cease
making investments in a project.

Lecture 2 Ch9

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Chapter Outline

9.1 The Capital Budgeting Process

Copyright © 2023 Pearson Canada Inc. 9-1

Copyright © 2023 Pearson Canada Inc. 9-2

• Incremental Revenue and Cost Estimates

Copyright © 2023 Pearson Canada Inc. 9-3

• Operating Expenses Versus Capital Expenditures

Copyright © 2023 Pearson Canada Inc. 9-4

• Capital Expenses and Capital Cost Allowance

Copyright © 2023 Pearson Canada Inc. 9-5

• Capital Budgeting with First-Year Half-Year Rule: CRA

Copyright © 2023 Pearson Canada Inc. 9-6

• Capital Budgeting with Straight Line Depreciation:

Copyright © 2023 Pearson Canada Inc. 9-7

• The incremental CCA deduction claimed at the end of

• The incremental UCC is calculated as:

Copyright © 2023 Pearson Canada Inc. 9-8

• Incremental Revenue and Cost Estimates

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• Incremental Earnings Forecast

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Incremental Blank Blank Blank Blank Blank Blank Blank

1 Sales - 26,000 26,000 26,000 26,000 -

2 Cost of Goods Sold - (11,000) (11,000) (11,000) (11,000) -

3 Gross Profit - 15,000 15,000 15,000 15,000 -

4 S&G expenses - (2,800) (2,800) (2,800) (2,800) -

6 Capital Cost Allowance - (1,688) (2,616) (1,439) (791) (435)

7 EBIT (15,000) 10,513 9,584 10,761 11,409 (435)

8 Income Tax @ 40% 6,000 (4,205) (3,834) (4,305) (4,564) 174

9 Unlevered NI (9,000) 6,308 5,751 6,457 6,845 (261)

10 Plus: CCA - 1,688 2,616 1,439 791 435

11 Less: Capital Expenditure (7,500) Blank Blank Blank Blank Blank

13 Free Cash Flows (16,500) 7,995 8,366 7,895 7,636 174

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3 Cash Requirement 0 0 Blank Blank Blank 0

4 Inventory 0 0 Blank Blank Blank 0

5 Receivables (15% of sales) 0 3,900 3,900 3,900 3,900 0

6 Payables (15% of COGS) 0 −1650 −1650 −1650 −1650 0

7 Net Working Capital 0 2,250 2,250 2,250 2,250 0

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