Chapter8b

Chapter8b - Chapter 8 (Contd) Fundamentals of Capital...

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Chapter 8 (Cont’d) Fundamentals of Capital Budgeting
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Spring 2011 2 Focusing Question Your car broke down last week. You took it to the auto shop and the mechanic charged $5,000 to fix it. You estimated that the market value of the car would be $7,000 if it was still running so you agreed to pay for the repair. However, yesterday your car broke down again. You took it back to the auto shop and this time the mechanic asked for $3,000 to fix it. What will you do and why?
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Spring 2011 3 Outline Capital Budgeting Tax Shield Approach Incremental Earnings Approach Forecasting Incremental Earnings Analyzing the Project Common Pitfalls Converting Earnings to Cash Flows Replacement Decisions Other Adjustments
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Spring 2011 4 Learning Objectives 1. Compute the after-tax salvage value of selling a machine. 2. Explain the common pitfalls when identifying a project’s incremental free cash flows, including opportunity costs, project externalities and sunk costs. 3. Compute depreciation tax shield and apply the tax shield approach to directly determine a given project’s incremental free cash flows. 4. Evaluate a replacement project by computing the incremental cash flows using the tax shield approach. 5. Describe the methods that can be used to assess the sensitivity of a project’s NPV to changes in the assumptions.
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Spring 2011 5 Cash Flows in a Typical Project
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Spring 2011 6 More Adjustments to Free Cash Flow Liquidation or Salvage Value Book value of the asset = purchase price – accumulated depreciation If the sale price (SV) is different from the book value (BV), there will be a tax effect. If SV > BV, a capital gain tax due If SV < BV, a capital loss tax credit After-Tax Cash Flow from Asset Sale Sale Price Capital Gain) = −τ× t c
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Spring 2011 7 8-7 Computing After-Tax Salvage Value Problem: For the HomeNet’s example, suppose that the $7.5 million lab equipment can be sold for $800,000 when the production discontinues and the lab is shut down in year 4. What adjustments must we make to HomeNet’s free cash flow? Solution: Plan: 1. Compute accumulated depreciation and determine the book value of equipment at end of year 4. 2. Compute difference between sale price and book value. 3. Compute tax credit/due on capital loss/gain and subtract it from the sale price.
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Spring 2011 8 8-8 Computing After-Tax Salvage Value Execute: BV = $1.5mil in year 4 capital loss = $1,500,000 - $800,000 = $700,000 tax credit = 0.4 × $700,000 = $280,000 after-tax cash flow from selling the equipment: = $800,000 + $280,000 = $1,080,000 Evaluate: $1,080,000 will need to be added to HomeNet’s free cash flow in year 4. As sale price is lower than book value, there will be a capital loss which leads to tax credit.
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Spring 2011 9 More Adjustments to Free Cash Flow Timing of Cash Flows Cash flows may be monthly, quarterly, or annual.
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Chapter8b - Chapter 8 (Contd) Fundamentals of Capital...

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