Basic Corporate Finance 2-200-97A

1. Basic Corporate Finance 2-200-97A Lecture 6: Making Capital Investment Decisions

2. 2 Today‘s Agenda Review Quiz Results Digression: Personal Taxation Session 6: Making Capital Investment Decisions Identifying Relevant Cash Flows Projecting Cash Flows Depreciation and Taxes Examples and Exercises

3. Digression: Personal TaxationOverview Taxes are financial charges imposed on an individual or a legal entity such as corporation by a government and/or a province. An ideal tax system should Distribute the tax burden equitably Not change the efficient allocation of resources by the market Be easy to administer Taxable income includes Labor income (i.e. income from employment) Interest income Dividend income Capital gains income 3

4. Digression: Personal TaxationOverview Possible tax systems Proportional Tax Progressive Tax Regressive Tax Different sources of income are taxed differently. Employment income is taxed at current income tax rates. Interest income is taxed at the same tax rates as employment income. Dividend income is taxed at lower tax rates than income tax rate due to a dividend tax shelter that partially prevents double taxation of corporate earnings and encourages investors to invest in Canadian companies. Capital gains is also taxed at lower tax rates. 4

5. Digression: Personal TaxationCanadian Federal Taxes Marginal tax rate for dividends can be negative due to dividend tax credit (a tax formula that reduces the effective tax rate on dividends) 5

6. Digression: Personal TaxationQuebec Federal and Provincial Taxes 6

7. Digression: Personal TaxationAverage versus Marginal Tax Rates Average tax rate is the tax bill divided by the taxable income. Marginal tax rate is the tax rate you would pay if you earned one more dollar. If taxes are equal for all income levels, the marginal tax rate is the average tax rate. If higher income is taxed at higher rates, the marginal tax rate is  the average tax rate. 7

8. Digression: Personal TaxationTaxation Rules 8

9. Digression: Personal TaxationValuation After Taxes (Stocks) The marginal tax rate (tm) and the required rate of return after taxes for the stock (r*) will be given. Find the dividend tax rate using the formula tdiv = 1,45 * tm – 0,4026 . Convert all before-tax dividends to after-tax dividends by After tax dividends = D* = D x (1 – tdiv). Calculate the price of the stock at the time of sale taking the capital gains tax into account Calculate the price using after tax dividends as well as the after tax required rate. e.g. for Gordon growth model the after tax price is P* = D*/(r*-g) 9

10. Digression: Personal TaxationValuation After Taxes (Stocks) Stock ABC has just paid its annual dividend of $1 per share and the dividends are expected to grow at an annual rate of 10%. The next dividend is exactly one year from today and the stock is expected to sell for a price of $15.56 at the end of the 3rd year right after the dividend payment. The required rate of return on this stock before taxes is 14%. Véronique is an investor whose marginal tax rate is 45% and she requires a return of 11% on this stock. Her investment horizon is 3 years, i.e. she is planning to buy this stock today and sell it after 3 years. (No reinvestment of dividends) What is the market price of this stock as of today? What is the value of this stock after taxes for Véronique? Is this a good investment for Véronique? What is the annualized after tax holding period return for Véronique? (HPR = total return on stock over period it is held. sum of all income and capital gains divided by the initial period value. HPR=(Income+(Pt-P0))/P0) Is this a good investment for Véronique? 10

11. Digression: Personal TaxationValuation After Taxes (Bonds) The marginal tax rate (tm) and the required rate of return after taxes for the bond (r*) will be given. Convert all before-tax coupons to after-tax coupons by After tax coupon = C* = C x (1 – tm). Calculate the price of the bond at the time of sale taking the capital gains tax into account Calculate the price using after tax coupons as well as the after tax YTM. e.g. the after-tax price is 11

12. Digression: Personal TaxationValuation After Taxes (Bonds) Bond XYZ has just paid its semi-annual coupon of $50 per bond and the coupon rate is constant. The bond will expire in exactly ten years and its face value is $1,000. The YTM on this bond as of today is 12% (APR). Simon is a Quebec investor whose marginal tax rate is 55%. He expects a 7% after-tax YTM on this bond. He has an investment horizon of 5 years so he wants to buy this bond today and sell it after 5 years. What is the market price of this bond as of today? What is the after-tax value of this bond for Simon if the YTM is 13% for this bond after 5 years? (No reinvestment of coupons) Is this a good investment for Simon? What is the annual after tax holding period return for Simon? Is this a good investment for Simon? 12

13. Making Capital Investment Decisions 13

14. Identifying Relevant Cash FlowsIntuition Relevant cash flows: The incremental (marginal) cash flows. Incremental cash flows for project evaluation consist of any and all changes in the firm’s future cash flows that are a direct consequence of taking the project, including those that will occur and will not occur. Stand-alone principle: In theory, we should be interested in the marginal present value of a project. Assuming that running a project does not affect the appropriate discount rate of non-related (i.e. non-incremental) cash flows of the firm allows the evaluation of a project in isolation from the firm by focusing on the project’s incremental cash flows. 14

15. Identifying Relevant Cash FlowsIncremental Cash Flows EXCLUDE Sunk Costs: Expenses that must be paid whether or not the project is accepted, including all past costs, whether associated with the project or not. Financing costs: Only cash flow from assets, not financing costs such as interest expenses are considered. NPV uses the cost of capital to incorporate financing costs into the decision rule. Allocated overhead: Administration costs that exist with or without the project. 15

16. Identifying Relevant Cash FlowsIncremental Cash Flows INCLUDE Opportunity costs: Benefits forgone in order to accept the project. Side effects: Impacts on other projects from accepting this project. Net working capital: Increased cash and short-term asset requirements. Tax: Corporate income tax and adjustments from capital cost allowance. 16

17. Projecting Cash FlowsCash Flow Definitions 17

18. Projecting Cash FlowsExample – Pro Forma Income Statement 18

19. Projecting Cash FlowsExample – Projected Capital Requirements 19

20. Projecting Cash FlowsExample – Projected Total Cash Flows 20

21. Projecting Cash FlowsExample – Project Evaluation Now that we have the cash flows, we can apply the techniques that we learned in the last session Assume the required return is 20% Enter the cash flows into the calculator and compute NPV and IRR CF0 = -110,000; C01 = 51,780; F01 = 2; C02 = 71,780 NPV; I = 20; CPT NPV = 10,648 CPT IRR = 25.8% Should we accept or reject the project? 21

22. Projecting Cash FlowsNet Working Capital Why do we have to consider changes in NWC separately? GAAP requires that sales be recorded on the income statement when made, not when cash is received GAAP also requires that we record cost of goods sold when the corresponding sales are made, regardless of whether we have actually paid our suppliers yet Finally, we have to buy inventory to support sales although we haven’t collected cash yet 22

23. Projecting Cash FlowsThree Step Approach Initial Cash Flow Initial Investment in the project Opportunity Costs Addition to Net Working Capital Annual Cash Flow Revenues Expenses Depreciation Tax Shields Terminal Cash Flow Sale of assets Capital Gain Recovered Net Working Capital 23

24. Depreciation and TaxesDepreciation – Overview Definition: The amount of an asset’s value that you are allowed to deduct from taxable income each year. Depreciation is a non-cash expense, consequently, it is only relevant because it affects taxes Depreciation tax shield = D T, where D = depreciation expense and T = marginal tax rate Asset classes: Intangible assets (straight-line depreciation). Tangible assets (declining balance method or Capital Cost Allowance). Depreciation is not cash flow and should not be considered as such when calculating NPV. Depreciation is a tax-deductible expense. We must consider the tax savings linked to depreciation as positive cash flow in NPV calculation. The depreciation expense used for capital budgeting should be calculated according to the capital cost allowance schedule dictated by the tax code 24

25. Depreciation and TaxesDepreciation – Overview Need to know which asset class is appropriate for tax purposes Straight-line depreciation D = (Initial cost – salvage) / number of years Very few assets are depreciated straight-line for tax purposes Declining Balance Multiply percentage given in CCA table by the un-depreciated capital cost (UCC) (“Not-yet-depreciated capital cost”, i.e. cost left for further depreciation) Half-year rule Can use PV of CCA Tax Shield Formula (see later) 25

26. Depreciation and TaxesStraight Line Depreciation Straight-line depreciation is the simplest depreciation technique, in which the company estimates the "salvage value" of the asset after the length of time over which it is depreciated, and assumes the drop in the asset's value is in equal, constant yearly increments over that amount of time. The salvage value is an estimate of the value of the asset at the time it will be sold or disposed of; it may be zero. Present Value of the depreciation tax shield for a straight-line depreciation method C=capital cost, v=number of years over which asset will be depreciated, r = required rate of return on the company, t = marginal tax rate, t = time until disposal. Compare to PV formula for annuity. 26

27. Depreciation and TaxesStraight Line Depreciation - Example Suppose you bought a manufacturing equipment for $100,000 today and you estimate the salvage value would be $20,000. Then, the value of the equipment with respect to straight-line depreciation is as follows 27

28. Depreciation and TaxesCapital Cost Allowance Capital Cost Allowance is depreciation for tax purposes in Canada and does not necessarily correspond to GAAP depreciation. CCA is deducted before taxes and acts as a tax shield. Half-year rule: Figure CCA on 50% of an asset’s installed cost for its first year of use. Every capital assets is assigned to a specific asset class by the government. Every asset class is given a depreciation method and rate. 28

29. Depreciation and TaxesCapital Cost Allowance – Example Firm buys Van for 30,000 and (by law) has to capitalize it (no rational business would capitalize an item it could declare as an expense) 29

30. Depreciation and TaxesPresent Value of CCA Tax Shields PVCCATS is the present value of tax shield provided by capital cost allowances. If the company disposes of the asset at some point in the future, they have to give up the present value of the disposed tax shield The company bought an asset for $C The CCA rate for this class of asset is d The required rate of return on the company is r The marginal tax rate is t The company keeps the asset pool open forever … S is the salvage or disposal value of the asset in t years. 30

31. Examples and ExercisesExample: Salvage Value You purchase equipment for $100,000 and it costs $10,000 to have it delivered and installed. Based on past information, you believe that you can sell the equipment for $17,000 when you are done with it in 6 years. The company’s marginal tax rate is 40%. If the applicable CCA rate is 20% and the required return on this project is 10%, what is the present value of the CCA tax shield? The delivery and installation costs are capitalized in the cost of the equipment 31

32. Examples and ExercisesExercise 1 MEL Inc. is a company that produces watches. Its low weekly production of 500 units obliges it to keep an average inventory of $100,000, which is relatively high for the size of the company. A proposed solution is to purchase a new machine with a higher production capacity. By doing so, the inventory could be reduced to a level of $20,000. The new machine would cost $500,000 including installation expense. This machine would have a service life of 7 years and a resale value of $50,000 and it would need be serviced at the end of the 6th year that would cost $20,000 in depreciable expenses. The new machine would create additional $60,000 per year in before tax cash flows for the company compared to the old machine. The old machine was purchased 5 years ago for $200,000. Its current commercial value is approximately $100,000 and its commercial value would be $20,000 in 7 years and it does not need to be serviced in 6 years. Find the NPV of this project if the marginal tax rate for MEL Inc is 40% and the required rate of return for this project is 10%. The CCA rate for this category of machines is 20% and the asset pool will NOT be terminated after 7 years. 32

33. Examples and ExercisesExercise 2 Sonno Inc. makes and sells chairs in the Montreal metropolitan area. The company has a piece of land purchased a few years ago for $150,000, and is planning on building a facility on it to sell its products. Building the facility will cost $350,000. In order to see if its chairs are popular in Quebec, Sonno ordered a market study which had a cost of $20,000. The market study showed that the company could sell its products in Quebec for the next 5 years. After 5 years, Sonno should close its doors. At that time, the land is estimated to be worth $100,000, and the building $160,000. The building will be depreciated at a 15% decreasing rate. The market study also found the following: Units sold per year: 1,000 Variable costs: $15 per unit Addition to NWC at the beginning of the project: $5,000 The required rate of return for this type of project is 14%, and the marginal tax rate 30%. Using the NPV rule, what should be the minimum selling price per unit? 33

34. Examples and ExercisesExercise 3 JS. Inc. is considering the possibility to invest in a new production facility. To start the project, the company has to purchase a piece of land that costs $200,000. Then, it will build a building at a cost of $100,000 (depreciation class of 10%). After 1 year, it will be able to install equipment, at a cost of $50,000 (depreciation class of 30%), which will allow the sale of the old equipment for $4,000. This will bring net revenues of $85,000 before taxes and depreciation each year, until the end of 15 years. It is also estimated that the inventory will increase with $4,000, the accounts payable by 6% of the net revenues, and the accounts receivable by 4% of the net revenues. However, it is estimated that 5 years after purchase, the equipment will need reconditioning of $10,000. Assume that the building and the equipment will have zero resale value at the end of the project. The value of the land though will increase at a rate of 10% per year. It will be sold at the end of the project. Calculate the NPV of the project if JS. has a tax rate of 50% and it requires a rate of return of 16%. 34