Chapter 22
Capital Budgeting: A Closer Look
Copyright © 2003 Pearson Education Canada Inc.
Slide 22-214
Income Taxes and Capital Budgeting
• Income taxes are cash disbursements which impact on
cash flows
• Always consider the marginal tax rate or the rate paid on
any additional amounts of pretax income
• Consider operating cash flows on a after-tax basis:
After-tax savings = $6,000 x (1 - tax rate of 40%) = $3,600
With $6,000
Current
Saving
Revenues
Expenses
Net income before tax
tax (40%)
Net income after tax
Copyright © 2003 Pearson Education Canada Inc.
$100,000
70,000
30,000
12,000
$28,000
Difference
$100,000
64,000
36,000
9,600
$24,400
$0
6,000
6,000
2,400
$3,600
Page 810
Slide 22-215
Capital Cost Allowance
• Federal Income Tax Act (ITA) does not permit a
company to deduct amortization (depreciation) in
determining taxable income
• ITA does allow companies to deduct capital cost
allowance (CCA) which is similar to amortization
• ITA assigns assets to specific CCA classes
• Undepreciated Capital Cost (UCC) correspond to
Net Book Value in accounting terms
• ITA limits the rate of CCA to be half of the regular
rate in the first year for most assets (half-year
rule)
Copyright © 2003 Pearson Education Canada Inc.
Pages 811 - 812
Slide 22-216
Capital Cost Allowance (CCA) Classes
Class 1
4%
Buildings acquired after 1987
Class 8
20%
Capital property, machinery and
equipment not included in other
classes
Class 10
30%
Automotive equipment, electronic
data processing equipment
Class 12 100%
Software, tools costing less than $200
Class 39
Manufacturing and processing
equipment acquired after 1987
(40%, 35%, 30%, 25%)
Copyright © 2003 Pearson Education Canada Inc.
Page 830
Slide 22-217
CCA Calculations
• CCA is similar to declining balance amortization
• Cash saving on taxes (tax shield) due to the
deductibility of CCA = CCA x tax rate %
Present value
of tax savings
=
Cxt
x
d
d+k
x
2 +k
2 ( 1 + k)
Where: C = investment, t = tax rate, d = CCA rate, k = required rate of return
Present value of tax savings
= $10,000 x 40%
x
20%
20% + 10%
x
2 + 10%
2 (1 + 10%)
= $2,548
Copyright © 2003 Pearson Education Canada Inc.
Pages 811 - 812
Slide 22-218
CCA Table
Year
1
2
3
4
5
6
7
8
9
10
11
12
Beginning
Balance
$0
9,000
7,200
5,760
4,608
3,686
2,949
2,359
1,887
1,510
1,208
966
Additions
Net
Disposal Balance
$10,000
Copyright © 2003 Pearson Education Canada Inc.
$10,000
9,000
7,200
5,760
4,608
3,686
2,949
2,359
1,887
1,510
1,208
966
CCA
CCA
Ending
Rate Amount Balance
10% $1,000
20% 1,800
20% 1,440
20% 1,152
20%
922
20%
737
20%
590
20%
472
20%
377
20%
302
20%
242
20%
193
Pages 811 - 812
$9,000
7,200
5,760
4,608
3,686
2,949
2,359
1,887
1,510
1,208
966
773
Slide 22-219
Trade-ins and Disposal of Capital Assets
• CCA system works on a pool basis
• If buy a new asset for $12,000 with a $4,000 trade-in,
add $8,000 to the pool
• Undepreciated capital cost (UCC) is the balance of
CCA remaining on the books at any point in time
• UCC is equivalent to “net book value” in financial
accounting
• Ignore the UCC balance in the pool for the capital
asset that was traded in
• Note that the half-year rule does not apply to CCA
calculations when capital assets are sold
Copyright © 2003 Pearson Education Canada Inc.
Pages 813 - 814
Slide 22-220
Capital Budgeting and Inflation
• Inflation is the decline in the general purchasing
power of the monetary unit
• Normal, expected inflation is included in the nominal
(or normal) required rate of return
• Include inflation in capital budgeting model if
significant over the life of the project
• Nominal Approach: predict cash inflows and
outflows in nominal monetary units and use a
nominal rate as the required rate of return
• Real Approach: predict cash inflows and outflows in
real monetary units and use a real rate as the
required rate of return
Copyright © 2003 Pearson Education Canada Inc.
Pages 820 - 823
Slide 22-221
Project Risk and Required Rate of Return
•
Organizations typically use at least one of the
following approaches in dealing with project risk
1. Varying the required payback time (higher the risk,
the shorter the desired payback time)
2. Adjusting the required rate of return (use a higher
required rate for risky projects)
3. Adjusting the estimated future cash inflows (reduce
cash flows for riskier projects)
4. Sensitivity (what-if) analysis
5. Probability distributions (to account for uncertainty)
Copyright © 2003 Pearson Education Canada Inc.
Pages 824 - 825
Slide 22-222