0804--01 - CAPITAL BUDGETING: Present value analyses with...

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Unformatted text preview: CAPITAL BUDGETING: Present value analyses with tax effects Cash flows In capital budgeting, managers are interested in optimizing (e.g., maximizing) return on investment. Accordingly, it is necessary to consider all expected cash flows associated with a given decision (project) if return on investment is to be properly analyzed. In general, there are three fundamental categories of cash flows associated with any given project: (1) investment cash flows, (2) operating cash flows, and (3) terminal cash flows. Example 1/1/97 1997 1998 1999 Investment in project .............................................. ($50,000) Operating cash flows -Revenues .................................................................................................................... $60,000 $60,000 $60,000 Variable costs .............................................................................................................. -30000 -30000 -30000 Fixed costs ................................................................................................. -15000 -15000 -15000 Operating CF -- net ................................................................15000 15000 15000 Disposal of equipment .............................. Project net cash flows ..........................$15,000 ($50,000) 2 0000 $15,000 $35,000 Operating cash flows In general, it is usually assumed in capital budgeting that expected accounting profits (i.e., revenues minus costs) are equivalent to expected cash flows. While there are various reasons for managers use of this assumption, one common reason is that managers tend to view accounting profits as a relatively close approximation of "operating" cash flows. Depreciation The periodic accounting recognition of the cost of investments in property and equipment as depreciation generally represents the primary difference between accounting profits and operating cash flows. Depreciation, then, is usually added back to accounting profits to obtain operating cash flows in most capital budgeting analyses. Example 1/1/97 1997 1998 1999 Investment in project .............................................. ($50,000) Operating cash flows (1) -Revenues .................................................................................................................... $60,000 $60,000 $60,000 Variable costs .............................................................................................................. -30000 -30000 -30000 Fixed costs ................................................................................................. -15000 -15000 -15000 A dd depreciation ...................................................... 12000 12000 12000 Operating CF -- net ................................................................27000 2 7000 27000 Disposal of equipment .............................. Project net cash flows ..........................$27,000 ($50,000) 2 0000 $27,000 $47,000 (1) Includes $10,000 depreciation per period in fixed costs. Therefore, depreciation must be added back to obtain an estimate of operating cash flows. Income taxes Income taxes often represent a significant factor affecting firms' profits (e.g., the average U.S. corporate income tax rate is around 34% of taxable income or "profits"). Accordingly, managers must generally consider how income taxes affect the profitability and cash flows of a project under consideration. In general, depreciation affects the computation of taxable income (loss) from a firm's operating activities, as well as the initial project investment and project terminal cash flow, since depreciation: (1) is deductible for income tax purposes; and (2) reduces the tax basis of investments in property and equipment and, therefore, taxable gain (loss) from project disposals. Example 1/1/97 1997 1998 1999 Investment in project .............................................. ($50,000) Operating cash flows -Revenues .................................................................................................................... $60,000 $60,000 $60,000 Variable costs .............................................................................................................. -30000 -30000 -30000 Fixed costs (w/ depr) ................................................................................................. -15000 -15000 -15000 Profit before taxes ............................................................................................... 15000 15000 15000 Income taxes @ 34% ............................-5100 -5100 -5100 Total -- net ........................................................................................... 9900 9900 9900 A dd depreciation ...................................................... 12000 12000 12000 Operating cash flows .................................................................................. 2 1900 21900 21900 Disposal of equipment .............................. Project net cash flows ..........................$21,900 ($50,000) 2 0000 $21,900 $41,900 Computation of terminal cash flow Cash flow Cash proceeds from sale of equipment .......................................................... $23,091 Less applicable income taxes ................................................................................... -3090.9091 Cash proceeds -- net of tax ............................................................................. $20,000 Taxable gain (loss) and applicable income taxes Cash proceeds from sale of equipment .......................................................... $23,091 $23,091 Less adjusted tax basis of equipment: Original cost ......................................................................................................... $50,000 A ccumulated depreciation .............................................................................................. (36,000) A djusted tax basis of equipment ....................................................................................... (14,000) Taxable gain (loss) ................................................................................... 9,091 Effective income tax rate ................................................................................. 34% Applicable income taxes ................................................................................... $3,091 -3090.9091 Cash proceeds from sale of equipment (net of applicable taxes) .............................. $20,000 NPV comparison NPV@5% 1/1/97 1997 1998 1999 No depreciation, no taxes .................................................................. $7,739 ($50,000) $15,000 $15,000 $35,000 W ith depreciation, no taxes .................................................................. $38,861 ($50,000) $27,000 $27,000 $47,000 W ith depreciation and taxes .................................................................. $25,634 ($50,000) $21,900 $21,900 $41,900 Summary (1) In general, only cash flows are relevant to NPV analyses. (2) Initial cash flows, operating cash flows and terminal cash flows for a given project are, in general, all relevant to NPV analyses. (3) Depreciation becomes relevant to NPV analyses when tax effects are considered. (4) Income taxes are generally relevant to NPV analyses. n ...
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This note was uploaded on 01/13/2012 for the course ACC 202 taught by Professor Sue during the Fall '10 term at Michigan State University.

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