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4. Appraise the use of the cost of capital as the discount rate in capital budgeting analysis.
(LO 4 )
5. Integrate the cash flows that result from an investment decision, including the after tax operating benefits and the tax shield benefits of capital cost allowance (amortization). (LO 5 )
6. Perform NPV analysis to assist in the decisionmaking process concerning long-run investments. (LO 6 )
©2012 McGraw-Hill Ryerson Limited

LO6
• When estimating cash flows for an investment proposal, remember that only those cash flows resulting from the potential acceptance decision are relevant and should be included in your estimation.
• For example, a proposal of purchasing a new van to replace an old van should only include the net cost of the new van, that is, the difference between the cost of the new van and the sale price of the old van.
• The present value of CCA tax shield =
[ C pv

S pv
] 

 dT c 




 r
1
 r



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Table 12-13
Net present value of resultant cash flows at
12%
LO6
Investment in Vans
Year
0
Cash Flow
Purchase vans
Amount
-$30,000
(1 – t)
---
Aftertax
Cash Flow
0
1-4
4
Sell old van
Operating
Salvage
500
17,000
4,000
---
0.61
---
$10,370
Present value of CCA tax shields ($30,000 - $500 - $2,542) (0.263647)*
Net present value of resultant cash flows and initial investment
*This number is from our calculation using formula 12-1
Present
Value
-$30,000
500
31,497
2,542
7,107
$11,646
©2012 McGraw-Hill Ryerson Limited

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Table 12-14
IRR solution framework using 25%
Investment in Vans
Year Cash Flow Amount (1 – t)
0
0
1-4
Purchase vans
Sell old van
Operating
-$30,000
500
17,000
4,000
---
---
0.61
--4 Salvage
Present value of CCA tax shields
($30,000 - $500 - $1,638) (0.30) (0.39) (1 + 0.5(0.25)
0.25 + 0.30 1 + 0.25
= $27,862 (0.212727) (0.90)
Net present value of resultant cash flows and initial investment
Aftertax
Cash Flow
$10,370
Present
Value
-$30,000
500
24,490
1,638
5,334
$1,962
LO6
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To make the actual investment decision:
1) determine the net cash outflow arising from the initial investment
2) estimate the amounts and timing of net future cash inflows (aftertax)
3) discount the future cash flows back to the present
4) add the present value of the Capital Cost Allowance shield, using the formula and appropriate CCA rate
5) determine whether the machine should be purchased
(if NPV > 0 )
LO6
©2012 McGraw-Hill Ryerson Limited

LO6
Table 12-15
Net price of the new computer
Price of the new computer . . . . . . . . . . . . . . . . . . . . . . . . $150,000
- Investment tax credit (15%) or $22,500 . . . . . . . . . . . . . 19,737*
Net price of new computer . . . . . . . . . . . . . . . . . . . . . . . . 130,263
- Cash inflow from sale of old computer . . . . . . . . . . . . . 40,000
Net cost of new computer . . . . . . . . . . . . . . . . . . . . . . . . . $ 90,263
* Our assumption about cash flows (revenues, expenses) and tax-initiated cash flows is that they occur at the end of the year. Therefore, the tax credit of
$22,500 is discounted one year. The CCA pool is affected in the year after acquisition. The CCA tax shield formula is constructed assuming tax savings effects occur at the end of the year.
6 of 45 ©2012 McGraw-Hill Ryerson Limited

LO6
Table 12-16
Differential analysis of new computer
Year
0
Cash Flow
New computer
Amount
-$90,263
(1
– Tax rate)
---
0
1
2
3
4
5
5
Working capital investment
Cost savings
Cost savings
Cost savings
Cost savings
Cost savings
Salvage
-5,000
20,000
38,000
40,000
45,000
45,000
30,000
---
0.61
0.61
0.61
0.61
0.61
---
0 Working capital recovery 5,000
Present value of CCA tax shield benefits … (from calculation)
---
Net present value
Aftertax
Cash Flow
---
---
12,200
23,180
24,400
27,450
27,450
---
---
Present Value
(@ 14%)
-$90,263
*The present value of all the cost savings may be handled in one output from the calculator, particularly if it is an annuity.
-5,000
10,702
17,836
16,469
16,253
14,257*
15,581
2,597
20,490
$18,922
7 of 45 ©2012 McGraw-Hill Ryerson Limited

LO6
• Both NPV and IRR models require the estimation of future expected cash flows and the selection of an appropriate opportunity cost of capital.
• There can be difficulties and mistakes estimating future cash flows.
• Also bias in estimates based by managers who wish to see their project accepted.
• Despite the use of models to determine the discount rate, its determination is a judgement call.
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