Agenda for today

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- Review moodle site
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- Emphasis on course outline
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- The CPA Way

- Excel will be tested on the midterm

- Cover Chapter 13 - Capital Budgeting

umana@yorku.ca
s on course outline

l be tested on the midterm

hapter 13 - Capital Budgeting

 TIME VALUE OF MONEY
The concept of time value of money implies that $1 received today is more valuable than $1 to be received in the future.

Why?
Because of INFLATION

A very simple example is as follows:

If I can buy a sweater for $100 today, due to inflationary pressures the selling price of that sweater will increase in the fut

Therefore, let us assume today is January 1, 2020

- We assume inflation runs at 2% increase year over year
- We will also assume that price increases occur at the beginning of each calendar year (January 1st)
- What will the selling price of that sweater be on January 1, 2030?

2020 2021 2022 2023

Today is January 1, 2020 $100 $102 $104.04 $106.12

Selling price on that $103.99 $105.99

day has been
established at
$100 per sweater

Inflation runs at
2%
year over year

Therefore, the price at January 1, 2021

will be:

Price at 1.1.2020 $100

Inflation:
1 + 2% 102%

Selling price at
1.1.2020 is equal to $102
be received in the future.

ter will increase in the future

ar (January 1st)

2024 2025 2026 2027 2028

$108.24 $110.41 $112.62 $114.87 $117.17

$108.99
 2029 2030

$119.51 $121.90

Therefore, the selling price of the sweater should be

$121.90 per sweater at January 1, 2030
 DISCOUNTED CASH FLOW METHODOLOGY

What does that mean?

In analyzing whether a company should invest in a project that has a long-term life of say 5, 10, 15 or 20 years we need to

So in keeping with the example of the sweater REQUIRED RATE OF RETU

And assuming our 'discount factor' is 2% we can show how the future values can be 'discounted' to today as follows:

2020 2021 2022 2023

100.00 102.00 104.04 106.12

Inflation runs at
2% 2 3 4
year over year 1 whole year
from 1.1.2020 to 12.31.2020
PRESENT VALUE TABLE
Present value of $1, that is (1+r)-n
Where r = interest rate
n =number of periods until payment or receipt

Periods Interest rate Discounted cash flow

(n) (r)
2%

1 0.980 99.96
2 0.961 99.98244
3 0.942 99.96579
4 0.924 100.0167
5 0.906 100.0297 Average discounted
6 0.888 100.0032 value is $99.99
7 0.871 100.0505
8 0.853 99.94255
9 0.837 100.0292
10 0.820 99.95754
 15 or 20 years we need to discount future cash flows to TODAY'S VALUE

REQUIRED RATE OF RETURN IS 2%

d' to today as follows: FROM THE PREVIOUS WORKSHEET WE ARRIVED AT THESE FUTURE VALUES

2023 2024 2025 2026 2027 2028

108.24 110.41 112.62 114.87 117.17

4 5 6 7 8 9

Average discounted
value is $99.99
URE VALUES

2028 2029 2030

119.51 121.90

9 10
PRESENT VALUE vs. ANNUITY

Now let us assume a project will generate free cash flow as follows:

Selling price $50 per unit Let us assume discount rate is 10%
Amount of units sold 1,000 And number of periods (or say years) is 1
Total yearly sales $50,000

Cost of goods sold per unit $30 per unit

Amount of units produced 1,000
Total cost of goods sold $30,000

Yearly free cash flow $20,000

PRESENT VALUE METHOD versus

Periods Interest rate Discounted cash flow

(n) (r) x
10%

1 0.909 $18,180.000
2 0.826 $16,520.000
3 0.751 $15,020.000
4 0.683 $13,660.000
5 0.621 $12,420.000
6 0.564 $11,280.000 different approach same re
7 0.513 $10,260.000
8 0.467 $9,340.000
9 0.424 $8,480.000
10 0.386 $7,720.000
$122,880.000
 FOR PRESENT VALUE OF $1 - PLEASE REFER TO PG 502 OF THE BLOCHER TEXT

FOR PRESENT VALUE OF ANNUITY OF $1 - PLEASE REFER TO PG 503 OF THE BLOCHER TEXT

scount rate is 10%

eriods (or say years) is 10 years

ANNUITY METHODOLOGY

$20,000 yearly cash flow

6.145 annuity factor (10 years, 10% discount rate OR required rate of return)
$122,900

erent approach same result

SALES

COGS

GM

V S&A
F S&A

OI

TAX RATE

NI
SIMPLE NET PRESENT VALUE CALCULATION

ABC Ltd. Is planning on investing $190,000 into a new piece of machinery. If accepted initial investment will oc

Intial working capital required is $15,000 to support the new operations. The product will sell for $50 a unit an
unit will be $30 per unit.

ABC LTd. Projects to produce and sell 2,200 units a year. The corporate tax rate is low at 15% on any profits

Capital cost allowance rate is = 20%

At the end of the 10 year project equipment initally costing $190,000 will have a $20,000 salvage value and wi
over the 10 year period. Required rate of return is 10%

Fixed expenses are as follows:

Fixed s&A expenses 9,800 Depreciation
Step 1 -> Calculate free cash flow on a yearly basis
Selling price $50 per unit
Amount of units sold 2,200
Total yearly sales $110,000

Cost of goods sold per unit $30 per unit

Amount of units produced 2,200
Total cost of goods sold $66,000 CCA
TAX SHIELD
Yearly free cash flow $44,000 FORMULA
C = The capital cost of the asset added to the
Sales $110,000 d = CCA rate
Cost of good sold $66,000 t = The firm's marginal tax rate
k = The weighted average cost of capital
Contribution margin $44,000 1 + 0.5k
To account for 1/2 year rule re income ta
1+k
Fixed S&A expenses -9,800

Annual cash flow $34,200

 this is the weighted average cost of capital
this is the discount factor or discount rate
ccepted initial investment will occur on January 1, 2021
this is the required rate of return
product will sell for $50 a unit and the cost to produce each

e is low at 15% on any profits

e a $20,000 salvage value and will be depreciated straight line

Year(s) Amount Tax Effect

20,500
Cost of new equipment Now -190,000
Working capital needed Now -15,000
Net annual cash receipts 1-10 34,200 (1 - 0.15)
Salvage value of equipment 10 20,000
Release of working capital 10 15,000
Present value of CCA tax shield:

PV = Cdt 1 + 0.5k - Sdt -n

x x (1 + k)
d+k 1+k d+k

al cost of the asset added to the asset pool $190,000 x 20% x 15% 1 + 0.05
x -
20% + 10% 1 + 0.10
marginal tax rate
hted average cost of capital $5,700 1.05
x -
30.00% 1.1
nt for 1/2 year rule re income tax legislation
$19,000.00 x 0.9545454545 -
$18,136.36 -
$17,364.36

if net present value is positive w

hted average cost of capital
unt factor or discount rate

red rate of return

Present
After-Tax Annuity Discount Value
Cash Factor Factor of Cash
Flows Flows

-190,000 -190,000.00
-15,000 -15,000.00
29,070 6.145 178,635.15
0.386 7,720.00
0.386 5,790.00

20,000 x 20% x 15% -10

x (1 + 0.10)
20% + 10%

600
x 0.386
30.00%

2000 x 0.386
772
17,364.36
NET PRESENT VALUE 4,509.51
THEREFORE ACCEPT

f net present value is positive we should accept

 cca rate cca tax rate @ 15% ucc today's dollars
190,000 20% 38000 5700 152,000 year 1 0.909 5181.3
152,000 20% 30400 4560 121,600 2 0.826 3766.56
121,600 20% 24320 3648 97,280 3 0.751 2739.648
97,280 20% 19456 2918.4 77,824 4 0.683 1993.2672
77,824 20% 15564.8 2334.72 62,259 5 0.621 1449.86112
62,259 20% 12451.84 1867.776 49,807 6 0.564 1053.425664
49,807 20% 9961.472 1494.2208 39,846 7 0.513 766.5352704
39,846 20% 7969.178 1195.37664 31,877 8 0.467 558.24089088
31,877 20% 6375.342 956.301312 25,501 9 0.424 405.471756288
25,501 20% 5100.274 765.0410496 20,401 10 0.386 295.305845146
18,209.62 cca tax shield
our tax savings
over the next
10 years discounted into today's
20,401 20% 4080.219 612.03283968 16,321 0.35 214.211493888
16,321 20% 3264.175 489.626271744 13,057 0.319 156.190780686
13,057 20% 2611.34 391.7010173952 10,445 0.29 113.593295045
10,445 20% 2089.072 313.3608139162 8,356 0.263 82.41389406
8,356 20% 1671.258 250.6886511329 6,685 0.239 59.9145876208
6,685 20% 1337.006 200.5509209063 5,348 0.218 43.7201007576
5,348 20% 1069.605 160.4407367251 4,278 0.198 31.7672658716
4,278 20% 855.6839 128.3525893801 3,423 0.18 23.1034660884
3,423 20% 684.5471 102.682071504 2,738 0.164 16.8398597267
2,738 20% 547.6377 82.14565720324 2,191 0.164 13.4718877813
2,191 20% 438.1102 65.71652576259 1,752 0.149 9.79176233863
765.02
 Capital cost allowance is just another way of saying Year 1
the expense that will be allowed to be deducted from taxable income sales
cogs
gross margin

fixed s&a costs

variable s&a costs

operating income

cca
cca tax shield
our tax savings taxable income
over the next
10 years discounted into today's dollars

PRESENT VALUE OF LOST TAX SAVINGS OF DISPOSING OF EQUIPMENT IN YEAR 10

FOR $20,000. ASSUME SOLD AT COST
 100,000
55,000
gross margin 45,000

fixed s&a costs 5,000

variable s&a costs 2,000

operating income 38,000

-38000

taxable income 0
 SIMPLE NET PRESENT VALUE CALCULATION

ABC Ltd. Is planning on investing $190,000 into a new piece of machinery. If accepted initial investment will oc

Intial working capital required is $15,000 to support the new operations. The product will sell for $50 a unit an
unit will be $30 per unit.
cogs will increase 2.2% year over year
ABC LTd. Projects to produce and sell 2,200 units a year. The corporate tax rate is low at 15% on any profits
sales will increase 5% year over year
Capital cost allowance rate is = 20%

At the end of the 10 year project equipment initally costing $190,000 will have a $20,000 salvage value and wi
over the 10 year period. Required rate of return is 10%

Fixed expenses are as follows:

Fixed s&A expenses 9,800 Depreciation
Step 1 -> Calculate free cash flow on a yearly basis
Selling price $50 per unit
Amount of units sold 2,200
Total yearly sales $110,000

Cost of goods sold per unit $30 per unit

Amount of units produced 2,200
Total cost of goods sold $66,000 CCA
TAX SHIELD
Yearly free cash flow $44,000 FORMULA
C = The capital cost of the asset added to
Sales $110,000 d = CCA rate
Cost of good sold $66,000 t = The firm's marginal tax rate
k = The weighted average cost of capital
Contribution margin $44,000 1 + 0.5k
To account for 1/2 year rule re incom
1+k
Fixed S&A expenses -9,800

Annual cash flow $34,200

YEAR 2021 2022 2023 2024 2025 2026

unit sold 2,200 2310 2425.5 2546.775 2674.11375 2807.819438

sp per unit $50 $50.55 $51.11 $51.67 $52.24 $52.81

total sales $110,000 $116,771 $123,958 $131,587 $139,687 $148,284

cogs $30 $30.66 $31.33 $32.02 $32.73 $33.45
units prod 2,200.00 2,310.00 2,425.50 2,546.78 2,674.11 2,807.82

total cogs $66,000.00 $70,824.60 $76,001.88 $81,557.62 $87,519.48 $93,917.15

fcf OR
gm $44,000.00 $45,945.90 $47,955.85 $50,029.71 $52,167.04 $54,367.08

fixed s&a -9,800 -9,800 -9,800 -9,800 -9,800 -9,800

annual free cash $34,200.00 $36,145.90 $38,155.85 $40,229.71 $42,367.04 $44,567.08

 f accepted initial investment will occur on January 1, 2021

he product will sell for $50 a unit and the cost to produce each
price will increase 1.1% year over year

rate is low at 15% on any profits

ave a $20,000 salvage value and will be depreciated straight line

Year(s)
20,500
Cost of new equipment Now
Working capital needed Now
Net annual cash receipts 1-10
Salvage value of equipment 10
Release of working capital 10
Present value of CCA tax shield:

PV = Cdt 1 + 0.5k - Sdt -n

x x (1 + k)
d+k 1+k d+k

he capital cost of the asset added to the asset pool $190,000 x 20% x 15%
x
20% + 10%
he firm's marginal tax rate
he weighted average cost of capital $5,700
x
30.00%
o account for 1/2 year rule re income tax legislation
$19,000.00 x

2027 2028 2029 2030

2948.210409 3095.62093 3250.40197634 3412.92208

$53.39 $53.98 $54.57 $55.17

$157,411 $167,100 $177,385 $188,303

 $34.18 $34.94 $35.70 $36.49
2,948.21 3,095.62 3,250.40 3,412.92

$100,782.49 $108,149.70 $116,055.44 $124,539.09

$56,628.63 $58,950.08 $61,329.33 $63,763.71

-9,800 -9,800 -9,800 -9,800

$46,828.63 $49,150.08 $51,529.33 $53,963.71

this is the weighted average cost of capital
this is the discount factor or discount rate

this is the required rate of return

Present
After-Tax Annuity Discount Value
Cash Factor Factor of Cash
Amount Tax Effect Flows Flows

-190,000 -190,000 -190,000.00

-15,000 -15,000 -15,000.00
34,200 (1 - 0.15) 29,070 6.145 178,635.15
20,000 0.386 7,720.00
15,000 0.386 5,790.00

1 + 0.05 20,000 x 20% x 15% -10

- x (1 + 0.10)
1 + 0.10 20% + 10%

1.05 600
- x 0.386
1.1 30.00%

0.9545454545 - 2000 x 0.386

$18,136.36 - 772
$17,364.36 17,364.36
NET PRESENT VALUE 4,509.51
THEREFORE ACCEPT

if net present value is positive we should accept

 cca rate cca tax rate @ 15% ucc today's dollars
270,000 25% 67500 20250 202,500 year 1 0.9174 18577.9816514
202,500 25% 50625 15187.5 151,875 2 0.8416 12781.8
151,875 25% 37968.75 11390.625 113,906 3 0.7721 8794.7015625
113,906 25% 28476.56 8542.96875 85,430 4 0.7084 6051.8390625
85,430 25% 21357.42 6407.2265625 64,072 5 0.6499 4164.05654297
64,072 25% 16018.07 4805.419921875 48,054 6 0.5962 2864.99135742
48,054 25% 12013.55 3604.064941406 36,041 7 0.547 1971.42352295
36,041 25% 9010.162 2703.048706055 27,030 8 0.5018 1356.3898407
27,030 25% 6757.622 2027.286529541 20,273 9 0.4604 933.362718201
20,273 25% 5068.216 1520.464897156 15,205 10 0.4224 642.244372559
58,138.79 cca tax shield
our tax savings
over the next
10 years discounted into today's
15,205 20% 3040.93 456.1394691467 12,164 0.35 159.648814201
12,164 20% 2432.744 364.9115753174 9,731 0.319 116.406792526
9,731 20% 1946.195 291.9292602539 7,785 0.29 84.6594854736
7,785 20% 1556.956 233.5434082031 6,228 0.263 61.4219163574
6,228 20% 1245.565 186.8347265625 4,982 0.239 44.6534996484
4,982 20% 996.4519 149.46778125 3,986 0.218 32.5839763125
3,986 20% 797.1615 119.574225 3,189 0.198 23.67569655
3,189 20% 637.7292 95.65938 2,551 0.18 17.2186884
2,551 20% 510.1834 76.527504 2,041 0.164 12.550510656
2,041 20% 408.1467 61.2220032 1,633 0.164 10.0404085248
1,633 20% 326.5174 48.97760256 1,306 0.149 7.29766278144
570.16
 Capital cost allowance is just another way of saying Year 1
the expense that will be allowed to be deducted from taxable income sales
cogs
gross margin

fixed s&a costs

variable s&a costs

operating income

cca
cca tax shield
our tax savings taxable income
over the next
10 years discounted into today's dollars

PRESENT VALUE OF LOST TAX SAVINGS OF DISPOSING OF EQUIPMENT IN YEAR 10

FOR $20,000. ASSUME SOLD AT COST
 100,000
55,000
gross margin 45,000

fixed s&a costs 5,000

variable s&a costs 2,000

operating income 38,000

-67500

taxable income -29,500