The depreciation expense used for capital budgeting should be the depreciation

The depreciation expense used for capital budgeting

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The depreciation expense used for capital budgeting should be the depreciation schedule required by the IRS for tax purposesDepreciation itself is a non-cash expense; consequently, it is only relevant because it affects taxesDepr. Tax Shield = D x T = (depr. expense ) x (marginal tax rate)After Tax Salvage Value (ATS)Selling assets: If the salvage value is different from the book value of the asset, then there is a tax effectPay taxes on a gain; Receive a tax benefit on a lossATS=Salvage Value–Tax Rate*(Salvage Value–Book value at time of sale)Problems/Conceptual:Depreciation:Straight-line to zero= Initial Cost / YearsStraight-line to salvage value= (Initial Cost - Salvage) / YearsMACRs= %Dt(Initial Cost)Asset Classes: 3-year(R&D Equipment); 5-year(Autos, Computers);
7-year(Industrial Equipment)Operating Cash flow of a projectBottom-Up ApproachOCF = Net income + depreciation Works only when there is no interest expenseTop-Down ApproachOCF = Sales - Costs - TaxesDon’t subtract non-cash deductionsTax Shield ApproachOCF = (Sales – Costs)(1 – T) + Depreciation*TMost frequently usedBypass pro-forma income statementCalculate Book value of an asset in a given year and After Tax Salvage ValueCalculate Cash flow from assets (CFFA):How to treat changes in NWCHow to treat ATS in the termination year of a project.How to calculate the equivalent annual cost (EAC) of a project.Chapter 14Problems/Conceptual:Cost of common equity (Re)- return required by equity investors given the risk of the cash flows from the firmCAPMRE = Rf+β[E(RM) – Rf ]Dividend Growth ModelStart with growing perpetuity; P0 = [D1/(RE-g)]Isolate the rate; RE = (D1/P0)+g
Cost of Preferred stocks (Rp)Preffered stock is perpetuity, so we rearrange the P0 formula for RPRP=D/P0

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