


The depreciation expense used for capital
budgeting should be the depreciation
schedule required by the Revenue Canada
for tax purposes
Depreciation itself is a non-cash expense;
consequently, it is only relevant because it
affects taxes
Depreciation tax shield = DT
◦ D = depreciation expense
◦ T = marginal tax rate
0



If the salvage value is different from the book
value of the asset, then there is a tax effect
Book value = initial cost – accumulated
depreciation
After-tax salvage = salvage – T(salvage –
book value)
Question: If a machine initially costs 120,00 and depreciated
straight-line to zero, and sold after 6 years at 20,000, what is the
after tax salvage value if tax rate is 40%?
1

Bottom-Up Approach
◦ Works only when there is no interest expense
◦ OCF = NI + depreciation

Top-Down Approach
◦ OCF = Sales – Costs – Taxes
◦ Don’t subtract non-cash deductions

Tax Shield Approach
◦ OCF = (Sales – Costs)(1 – T) + Depreciation*T
2
Assume we have the following background
information for a project being considered by
Gillis, Inc. See if we can calculate the project’s
NPV and payback period. Assume:
Required NWC investment = $40; project cost
= $60; 3 year life. Annual sales = $100;
annual costs = $50; straight line depreciation
to $0. Tax rate = 34%, required return = 12%

3
 Two golfing buddies are considering starting a new golf facility to there
entertainment company. Because of the growing popularity of golf, they estimate
the facility will generate rentals of 20,000 buckets of balls at $3 a bucket the first
year, and that rentals will grow by 750 buckets a year thereafter. The price will
remain $3 per bucket. Should they pursue this new venture?






Capital spending requirements include:
Ball dispensing machine
Ball pick-up vehicle
Tractor and accessories
$ 2,000
8,000
8,000
$18,000
 All the equipment is Class 10 CCA (30%), and is expected to have a salvage
value of 10% of cost after 6 years. (Assume that there are many assets in this
asset class apart from the golf business).
 Anticipated operating expenses are as follows:
4
Operating Costs (annual)
Land lease
Water
Electricity
Labor
$ 12,000
1,500
3,000
30,000
Seed & fertilizer 2,000
Gasoline
1,500
Maintenance
Insurance
1,000
1,000
Working Capital
Initial requirement = $3,000
Working capital requirements
are expected to grow at 5% per
year for the life of the project.
Company’s tax rate is 20%.
Cost of capital is 10%.
Misc. Expenses 1,000
$53,000
5
Year
Revenues
Fixed Costs
Depreciation
EBIT
Taxes (20%)
Net Income
1
2
3
4
5
6
$60,000
$62,500
$64,500
$66,750
$69,000
$71,250
53000
2,700
$4,300
$860.0
53000
4,590
$4,910
$982.0
53000
3213
$8,287
$1,657.4
53000
2249
$11,501
$2,300.2
53000
1574
$14,426
$2,885.2
53000
1102
$17,148
$3,429.6
$3,440.0
$3,928.0
$6,629.6
$9,200.8
$11,540.8
$13,718.4
6
Operating cash flows:
Year EBIT
0
$0
1
4,300
2
4,910
3
8,287
4
11,501
5
14,426
6
17,148
+
Depreciation –
$ 0
2,700
4,590
3,213
2,249
1,574
1,102
Taxes
-$ 0
- 860
- 982
-1657
- 2300
- 2885
- 3430
=
=
=
=
=
=
=
=
Operating
cash flow
$ 0
6140
8518
9843
11450
13115
14820
Total Cash flow from assets:
Year
0
1
2
3
4
5
6
OCF
$0
6140
8518
9843
11450
13115
14820
– Chg. in NWC
-$ 3,000
-150
-158
-165
-174
-182
+3829
– Cap. Sp.
-$18,000
0
0
0
0
0
+1,800
= Cash flow
= – $21,000
= 5590
= 8360
= 9678
= 11276
= 12933
= 20089
7

Straight-line depreciation

UCC
◦ D = (Initial cost – salvage) / number of years
◦ Very few assets are depreciated straight-line for
tax purposes
◦ Need to know which asset class is appropriate
◦ Follow procedure is done in Chapter 2
8
The Canadian CCA calculation means that depreciation tends to change over time.
Figuring out EBIT is rather involved, because it requires us to do an analysis for every
year. The tax shield approach is helpful in that regard, because it allows us to derive the
present value of the tax shield on CCA separately, instead of calculating the actual
savings for each year separately.
The idea is as follows: Note that CCA savings follows the following pattern
Time
Undepreciated
Depreciation
Tax Savings
capital cost (CCA)
1
C
Cd
CdT
2
C-Cd=C(1-d)
C(1-d)d
C(1-d)dT
2
2
3
C(1-d)
C(1-d) d
C(1-d)2dT
.
n
C(1-d)n
C(1-d)nd
C(1-d)ndT
9
IdTc
PV tax shield on CCA 
k d
1  0.5k 
 1  k 
S n dTc  1 
PV tax shield on CCA 

n
k  d  1  k  
10
An investment of 300k in a machine lasts for
5 years and then sold for 50k. The CCA rate
is 15%, tax rate is 40%, and the discount rate
is 20%. What is the PV of tax shields?
11
Ilana Industries, Inc., is considering buying a
new machine at a cost of 1M$. The machine
will cost $35,000 to run and will generate
products at a market value of $125,000 for
the next 10 years. The machine is an asset
class with a CCA rate of 25%, and Ilana has
many other assets in this asset class. The
salvage (market value) of the machine after
10 years is 100,000. The discount rate is 10%
and corporate tax rate is 35%. Calculate the
NPV of buying the machine.
12
Question
Bendog’s Franks is looking at a new system with an
installed cost of $450,000. This equipment is
depreciated at a rate of 20% per year (Class 8) over the
project’s six-year life, at the end of which the sausage
system can be sold for $100,000. The sausage system
will save the firm $105,000 per year in the pre-tax
operating costs, and the system requires an initial
investment in new working capital of $23,500. If the tax
rate is 37 percent and the discount rate is 12.5 percent,
what is the NPV of this project?
13
Consider a $10,000 machine that will reduce pretax operating
costs by $3,000 per year over a 5-year period. Assume no
changes in net working capital and a scrap (i.e., market) value of
$1,000 after five years.
For simplicity, assume straight-line depreciation to zero. The
marginal tax
rate is 34% and the appropriate discount rate is 10%.
14
Cash OutFlows in Dollars
Project:
C0
C1
C2
C3
PV @ 6%
Machine D
15
4
4
4
$25.69
Machine E
10
6
6
-
$21.00
15
 You are operating an old machine which will last 2
more years.
 It costs $12,000 per year to operate.
 A new machine costs $25,000 to buy, but is more
efficient and can be operated for $8,000 per year. It
will last for 5 years. Should you replace this year?
Should you replace next year?
Cash Flows in Dollars
Project:
C0
C1
C2
C3
C4
C5 PV @ 6%
New Machine
Equivalent
Annual cost:
25
8
8
8
8
8
$58.70
?
?
?
?
?
$58.70
16

Burnout Batteries
◦ Initial Cost = $36 each
◦ 3-year life
◦ $100 per year to keep
charged
◦ Expected salvage = $5
◦ Straight-line depreciation

Long-lasting Batteries
◦ Initial Cost = $60 each
◦ 5-year life
◦ $88 per year to keep
charged
◦ Expected salvage = $5
◦ Straight-line depreciation
The machine chosen will be replaced indefinitely and neither
machine will have a differential impact on revenue. No change
in NWC is required.
The required return is 15% and the tax rate is 34%.
17


Project interactions:
When we do NPV calculations, the idea is to
decide between pursing a project or not
pursuing the project. For example: we can
construct the building on a land we own, or we
can sell the land. For simple comparisons
between alternative, we typically do a
comparison in one step. For more complicated
cases, it is sometimes easier to do 2 NPV
calculations. However, we should always realize
that we can construct a project that includes
both alternatives.


18
Capital budgeting
Aqua-Products currently manufactures a wide range of equipment for water sports. The
company is re-evaluating its rubber rowboat product line to determine whether it will continue to
be profitable or whether it should be discontinued. Net operating revenues before tax (i.e., sales
minus all operating costs) are estimated to be $180,000 per year for each of the next 10 years.
It is estimated that the rubber rowboat product line has a useful life of 10 years; that is, after
year 10 no further revenues are anticipated from this particular product line and the economic
value of all machinery used to produce the rubber rowboats will be zero. Continued production
of this product line requires that finished goods inventory of rubber rowboats be maintained at a
level of $64,000 throughout the ten year life of the project. (If this product line were
discontinued, obviously the level of finished goods inventory of rubber rowboats would be
reduced to zero.)
If the rubber rowboat product line were shut down, there would be immediate expenses (100%
tax deductible) of $270,000. On the positive side, machinery formerly used in the production
process could be sold for $720,000. This machinery is in asset class 39, which is allowed a
CCA rate of 25%. The firm also has many other assets in this class. The floor space that is
vacated by the shutdown could be leased out at $75,000 per year. The firm’s tax rate is 40%,
and the appropriate discount rate is 14%.
Based on an NPV analysis, should Aqua-Products continue to manufacture rubber rowboats or
close down this one product line? Explain all the steps taken to reach your conclusion:
structuring of the problem and analysis should be explained in words as well as given by
calculations. Simply providing a numerical answer is not sufficient.
19



How do we determine if cash flows are
relevant to the capital budgeting decision?
What are the different methods for
computing operating cash flow and when
are they important?
What is equivalent annual cost and when
should it be used?
20
 A five year project has an initial fixed-asset
investment of $210,000, an initial NWC
investment of $20,000, and an annual OCF
of -$32,000. The fixed asset is fully
depreciated over the life of the project and
has no salvage value. If the required return
is 15 percent, what is this project’s
equivalent annual cost, or EAC?
21