Chapter

15 Income Taxes in Capital Budgeting Decisions

15-2

LEARNING OBJECTIVES After studying this chapter, you should be able to: 1. Compute the after-tax cost of a tax-deductible cash expense and the after-tax benefit from a taxable cash receipt. 2. Explain how capital cost allowance is computed. 3. Compute the tax savings arising from the capital cost allowance tax shield. 4. Compute the after-tax net present value of an investment proposal. 5. (Appendix 15A) Measure risk in assessing capital budgeting projects. © McGraw-Hill Ryerson Limited., 2001

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Income Taxes and Capital Budgeting The effects of income taxes on cash flows must be considered in capital budgeting decisions when an organization is subject to income taxes.

T2 © McGraw-Hill Ryerson Limited., 2001

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The Concept of After-Tax Cost Tax deductible expenses decrease the company’s net taxable income and reduce the taxes the company must pay. Let’s look at the East and West Companies example. East & West

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The Concept of After-Tax Cost East and West Companies are identical except that East has a $40,000 annual cash expense for an employee training program. Ea st Com pany Sales $ Le ss ex pe nse s: Sala ries, insura nce, etc. Training progra m Tota l ex pe nses Incom e before taxe s Le ss: incom e taxe s (30%) Net incom e $

250,000 150,000 40,000 190,000 60,000 18,000 42,000

W e st Com pany $

250,000

$

150,000 150,000 100,000 30,000 70,000

© McGraw-Hill Ryerson Limited., 2001

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The Concept of After-Tax Cost East and West Companies are identical except that East has a $40,000 annual cash expense for an employee training program.

The The after-tax after-tax cost cost of of the the training training program program Sales ($70,000 is is $28,000 $28,000 ($70,000 -Le ss ex pe nse s: $42,000). $42,000). Sala ries, insura nce, etc. Training progra m Tota l ex pe nses Incom e before taxe s Le ss: incom e taxe s (30%) Net incom e

Ea st Com pany $

250,000

$

150,000 40,000 190,000 60,000 18,000 42,000

W e st Com pany $

250,000

$

150,000 150,000 100,000 30,000 70,000

© McGraw-Hill Ryerson Limited., 2001

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The Concept of After-Tax Cost The following formula shows the after-tax cost of any tax-deductible cash expense: Tax-deductible After-tax cost = (1 – Tax rate) × cash expense = (1 – 0.30)

×

$40,000

= $28,000

© McGraw-Hill Ryerson Limited., 2001

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The Concept of After-Tax Cost The following formula shows the after-tax cost of any tax-deductible cash expense: Tax-deductible After-tax cost = (1 – Tax rate) × cash expense

The following formula shows the after-tax benefit of any taxable cash receipt: After-tax benefit = (1 – Tax rate) ×

Taxable Cash receipt © McGraw-Hill Ryerson Limited., 2001

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The Concept of After-Tax Cost North Company receives $80,000 per year from subleasing part of its office space. North is subject to a 30% tax rate.

What is the after-tax benefit from the sublease?

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The Concept of After-Tax Cost North Company receives $80,000 per year from subleasing part of its office space. North is subject to a 30% tax rate.

What is the after-tax benefit from the sublease? After-tax benefit = (1 – Tax rate) ×

Taxable Cash receipt

After-tax benefit = (1 – 0.30) × $80,000 = $56,000 © McGraw-Hill Ryerson Limited., 2001

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The Concept of After-Tax Cost South Company can invest in a project that would provide cash receipts of $400,000 per year. Cash operating expenses would be $280,000 per year. The tax rate is 30%.

What is the after-tax benefit (net cash inflow) each year from this project?

© McGraw-Hill Ryerson Limited., 2001

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The Concept of After-Tax Cost Annual Annual cash cash receipts receipts Annual Annual cash cash operating operating expenses expenses Annual Annual net net cash cash inflow inflow Multiply Multiply by by (100% (100% -- 30%) 30%) Annual Annual after-tax after-tax net net cash cash inflows inflows

$$400,000 400,000 280,000 280,000 120,000 120,000 70% 70% $$ 84,000 84,000

© McGraw-Hill Ryerson Limited., 2001

15-13

Capital Cost Allowance ! Capital cost allowance (CCA) is the

Canada Customs and Revenue Agency (formerly Revenue Canada) counterpart to amortization. ! For income tax purposes, amortization is not an allowable deduction. ! Instead, CCA is permitted by regulations that accompany the Canadian Income Tax Act. © McGraw-Hill Ryerson Limited., 2001

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Capital Cost Allowance ! Capital cost allowance is determined by

asset pools, or classes, that have prescribed rates. ! Capital cost allowance is calculated by applying the prescribed rates to a declining balance called undepreciated capital cost (UCC). [Exception: Class 13] ! Net additions in each year are only allowed a write-off of one-half of the prescribed rate (called the half-year rule). rule © McGraw-Hill Ryerson Limited., 2001

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Capital Cost Allowance Calculate CCA for a Class 8 (20%) pool of assets given the following: UCC, Jan. 1, 2000 $25,000 Acquisitions during year 15,000 Disposals during year, cost 5,000 Proceeds from disposals 3,000

Let’s see how this works!

© McGraw-Hill Ryerson Limited., 2001

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Capital Cost Allowance UCC, Jan 1, 2000 Acquisitions Disposals Net additions One-half of net additions UCC for CCA purposes CCA at 20%

$ 25,000 $ 15,000 (3,000) 12,000

Add back one-half of net additions UCC, December 31, 2000

6,000 31,000 6,200 24,800 6,000 $ 30,800

© McGraw-Hill Ryerson Limited., 2001

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Capital Cost Allowance UCC, Jan 1, 2000 $ 25,000 Acquisitions $ 15,000 Disposals (3,000) Net additions 12,000 One-half of net additions 6,000 UCC for CCA purposes 31,000 Disposals are CCA at 20% 6,200 always recorded at 24,800 the of the Add back one-half of netlesser additions 6,000 or the UCC, December 31, proceeds 2000 $ 30,800

original capital cost of the asset.

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Tax Consequences of Asset Disposals ❶ If proceeds of disposal exceed the UCC of the group of assets that make up the asset class, previously deducted CCA is recaptured.

❷ If proceeds exceed the original cost of the asset, there will be a capital gain. gain

❸ If all assets of a class have been disposed of, any remaining balance in UCC is fully deductible as a terminal loss. loss

Let’s try it! © McGraw-Hill Ryerson Limited., 2001

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Tax Consequences of Asset Disposals Beginning UCC Disposal of assets Capital cost Proceeds Capital gain UCC after disposition Recapture Terminal Loss Ending UCC

Case 1 Case 2 Case 3 Case 4 Case 5 $ 90,000 $ 90,000 $ 90,000 $ 90,000 $ 90,000 42,500 20,000

93,000 98,000

120,000 100,000

120,000 55,000

120,000 140,000

Note for this example that the Beginning UCC is always $90,000 but that the information regarding the disposal of assets varies. © McGraw-Hill Ryerson Limited., 2001

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Tax Consequences of Asset Disposals Beginning UCC Disposal of assets Capital cost Proceeds Capital gain UCC after disposition Recapture Terminal Loss Ending UCC

Case 1 Case 2 Case 3 Case 4 Case 5 $ 90,000 $ 90,000 $ 90,000 $ 90,000 $ 90,000 42,500 20,000 -0-

93,000 98,000 5,000

120,000 100,000 -0-

120,000 55,000 -0-

120,000 140,000 20,000

When Proceeds exceed Capital cost, there is a capital gain on disposal.

© McGraw-Hill Ryerson Limited., 2001

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Tax Consequences of Asset Disposals Beginning UCC Disposal of assets Capital cost Proceeds Capital gain UCC after disposition Recapture Terminal Loss Ending UCC

Case 1 $ 90,000 42,500 20,000 -070,000

Case 2 $ 90,000 93,000 98,000 5,000 (3,000)

Case 3 Case 4 $ 90,000 $ 90,000 120,000 100,000 -0(10,000)

120,000 55,000 -035,000

Case 5 $ 90,000 120,000 140,000 20,000 (30,000)

UCC after disposition = Beginning UCC minus the lesser of proceeds or original capital cost of disposed assets © McGraw-Hill Ryerson Limited., 2001

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Tax Consequences of Asset Disposals Beginning UCC Disposal of assets Capital cost Proceeds Capital gain UCC after disposition Recapture Terminal Loss Ending UCC

Case 1 $ 90,000 42,500 20,000 -070,000 -0-

Case 2 $ 90,000 93,000 98,000 5,000 (3,000) (3,000)

Case 3 $ 90,000 120,000 100,000 -0(10,000) (10,000)

Case 4 $ 90,000 120,000 55,000 -035,000 -0-

Case 5 $ 90,000 120,000 140,000 20,000 (30,000) (30,000)

When UCC after disposition is negative, that negative amount represents recaptured CCA and is included in calculating taxable income for the year. © McGraw-Hill Ryerson Limited., 2001

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Tax Consequences of Asset Disposals Beginning UCC Disposal of assets Capital cost Proceeds Capital gain UCC after disposition Recapture Terminal Loss Ending UCC

Case 1 Case 2 Case 3 Case 4 Case 5 $ 90,000 $ 90,000 $ 90,000 $ 90,000 $ 90,000 42,500 20,000 -070,000 -0-0-

93,000 98,000 5,000 (3,000) (3,000) -0-

120,000 100,000 -0(10,000) (10,000) -0-

120,000 55,000 -035,000 -035,000

120,000 140,000 20,000 (30,000) (30,000) -0-

A terminal loss arises when there is a balance remaining in the UCC after disposition but no assets remain in the asset pool, as shown in Case 4. This amount is fully deductible in calculating taxable income. © McGraw-Hill Ryerson Limited., 2001

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Tax Consequences of Asset Disposals Beginning UCC Disposal of assets Capital cost Proceeds Capital gain UCC after disposition Recapture Terminal Loss Ending UCC

Case 1 Case 2 Case 3 Case 4 Case 5 $ 90,000 $ 90,000 $ 90,000 $ 90,000 $ 90,000 42,500 20,000 -070,000 -0-070,000

93,000 98,000 5,000 (3,000) (3,000) -0-0-

120,000 100,000 -0(10,000) (10,000) -0-0-

120,000 55,000 -035,000 -035,000 -0-

120,000 140,000 20,000 (30,000) (30,000) -0-0-

Ending UCC will have a balance so long as there are assets remaining in the pool and there has been no recapture of CCA. © McGraw-Hill Ryerson Limited., 2001

15-25

Capital Cost Allowance Tax Shield Although capital cost allowance (CCA) is not a cash flow, it does have an impact on the amount of income taxes that a company will pay. CCA deductions shield revenues from taxation and thereby reduce tax payments.

Let’s look at an example of a capital cost allowance tax shield. © McGraw-Hill Ryerson Limited., 2001

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Capital Cost Allowance Tax Shield Art Art and and Music Music Companies Companies are are identical identical except except that that Art Art has has aa $60,000 $60,000 annual annual amortization amortization expense expense (=CCA (=CCA deduction): deduction): Art Company $ 500,000

Sales Less ex pense s: Cash operating ex pense s 340,000 Amortization expense 60,000 Total e xpenses 400,000 Income before taxe s 100,000 Less income tax es (30%) 30,000 Net income $ 70,000

Music Company $ 500,000 340,000 340,000 160,000 48,000 $ 112,000

© McGraw-Hill Ryerson Limited., 2001

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Capital Cost Allowance Tax Shield As As aa result result of of the the CCA CCA deduction, deduction, Art Art has has less less net net income income than than Music. Music. But But the the difference difference is is not not $60,000. $60,000. Art Company $ 500,000

Sales Less ex pense s: Cash operating ex pense s 340,000 Amortization expense 60,000 Total e xpenses 400,000 Income before taxe s 100,000 Less income tax es (30%) 30,000 Net income $ 70,000

Music Company $ 500,000 340,000 340,000 160,000 48,000 $ 112,000

© McGraw-Hill Ryerson Limited., 2001

15-28

Capital Cost Allowance Tax Shield Let’s look more closely at the difference in net income. Ne $$112,000 Nett incom incomee of of Music Music 112,000 Ne 70,000 Nett incom incomee of of Art Art 70,000 Difference 42,000 Difference in in net net incom incomee 42,000

We can compute the difference in net income as follows: $60,000 × (1 – 0.30) = $42,000 © McGraw-Hill Ryerson Limited., 2001

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Capital Cost Allowance Tax Shield The tax savings provided by the capital cost allowance tax shield is determined like this: CCA Tax × = Tax Shield rate

CCA deduction

= 0.30 × $60,000 = $18,000 Amortization Less: tax savings Difference in income

$60,000 18,000 $42,000 © McGraw-Hill Ryerson Limited., 2001

15-30

CCA Tax Shield Formula

PV =

Cdt d+k

x

1 + 0.5k 1+k

Where, PV = Present Value

C = capital cost of the asset added to the asset pool d = CCA rate t = marginal income tax rate k = cost of capital

© McGraw-Hill Ryerson Limited., 2001

15-31

CCA Tax Shield Formula

PV =

Cdt d+k

x

1 + 0.5k 1+k

Where

Represents correction C = capital costto of account the asset added to pool factor for halfd = CCA rate year rule during year of acquisition. t = marginal income tax rate k = cost of capital

© McGraw-Hill Ryerson Limited., 2001

15-32

CCA Tax Shield Formula The Tax shield is adjusted by deducting the PV of the salvage value

Sdt d+k

x

(1 + k) -n

Where S = salvage value of the asset added to the pool d = CCA rate t = marginal income tax rate k = cost of capital n = useful life of asset

Let’s see how this works!

© McGraw-Hill Ryerson Limited., 2001

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Capital Budgeting and Taxes Martin Company has an investment opportunity that would involve the following cash flows: Co s t o f ne w e q uip m e nt Wo rkin g c a p ita l re q uire d Ne t a nnua l c a s h re c e ip ts fo r 8 ye a rs Eq uip m e nt re p a irs in 4 ye a rs S a lva g e va lue o f e q uip m e nt

$ 4 0 0 ,0 0 0 8 0 ,0 0 0 1 0 0 ,0 0 0 4 0 ,0 0 0 5 0 ,0 0 0

© McGraw-Hill Ryerson Limited., 2001

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Capital Budgeting and Taxes ! The equipment has an estimated useful life

of 8 years. ! For tax purposes the equipment is a Class 8 asset with a 20% prescribed rate. ! Martin has an after-tax cost of capital of 10% and is subject to a 30% income tax rate.

Should Martin invest in this project? © McGraw-Hill Ryerson Limited., 2001

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Capital Budgeting and Taxes Flows Cost of new equipment Working capital needed Net annual cash receipts Equipment repairs Salvage value of equipment Release of working capital Subtotal Present value of CCA tax shield:

Years Now Now

After-Tax Amount Tax Effect Cash Flows (400,000) (400,000) (80,000) (80,000)

10% Present Factor Value 1.000 (400,000) 1.000 (80,000)

Start with current needs in today’s dollars

Net present value

© McGraw-Hill Ryerson Limited., 2001

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Capital Budgeting and Taxes Flows Cost of new equipment Working capital needed Net annual cash receipts Equipment repairs Salvage value of equipment Release of working capital Subtotal Present value of CCA tax shield:

Years Now Now 1- 8

Amount (400,000) (80,000) 100,000

Number of years of cash flows

Net present value

After-Tax Tax Effect Cash Flows (400,000) (80,000) 0.70 70,000

10% Present Factor Value 1.000 (400,000) 1.000 (80,000) 5.335 373,450

PV of an annuity @10% for 8 years

1 minus the tax rate (1 - 0.30) = 0.70 © McGraw-Hill Ryerson Limited., 2001

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Capital Budgeting and Taxes Flows Cost of new equipment Working capital needed Net annual cash receipts Equipment repairs Salvage value of equipment Release of working capital Subtotal Present value of CCA tax shield:

Net present value

Years Now Now 1- 8 4

Amount (400,000) (80,000) 100,000 (40,000)

Number of years until repair required

After-Tax Tax Effect Cash Flows (400,000) (80,000) 0.70 70,000 0.70 (28,000)

10% Present Factor Value 1.000 (400,000) 1.000 (80,000) 5.335 373,450 0.683 (19,124)

PV of $1 at 10% after four years

1 minus the tax rate (1 - 0.30) = 0.70 © McGraw-Hill Ryerson Limited., 2001

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Capital Budgeting and Taxes Flows Cost of new equipment Working capital needed Net annual cash receipts Equipment repairs Salvage value of equipment Release of working capital Subtotal Present value of CCA tax shield:

Years Now Now 1- 8 4 8 8

Amount (400,000) (80,000) 100,000 (40,000) 50,000 80,000

After-Tax Tax Effect Cash Flows (400,000) (80,000) 1-0.30 70,000 1-0.30 (28,000) 50,000 80,000

10% Present Factor Value 1.000 (400,000) 1.000 (80,000) 5.335 373,450 0.683 (19,124) 0.467 23,350 0.467 37,360 (64,964)

Net present value

Don’t forget, salvage value of equipment and release of working capital at end of eight year

PV of $1 at 10% after eight years

© McGraw-Hill Ryerson Limited., 2001

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Capital Budgeting and Taxes Flows Years Cost of new equipment Now Working capital needed Now Net annual cash receipts 1- 8 Equipment repairs 4 Salvage value of equipment 8 Release of working capital 8 Subtotal Present value of CCA tax shield: PV= 400,000 x .2 x .3 x 1.05 .2 + .10 1.10

{

Amount (400,000) (80,000) 100,000 (40,000) 50,000 80,000

After-Tax Tax Effect Cash Flows (400,000) (80,000) 1-0.30 70,000 1-0.30 (28,000) 50,000 80,000

50,000 x .2 x .3 .2 + .10

x

(1 + .10)

10% Present Factor Value 1.000 (400,000) 1.000 (80,000) 5.335 373,450 0.683 (19,124) 0.467 23,350 0.467 37,360 (64,964)

}

-8

Net present value

Finally, calculate the PV of the CCA tax shield adjusted for the salvage value at end of eight year © McGraw-Hill Ryerson Limited., 2001

15-40

Capital Budgeting and Taxes After-Tax Tax Effect Cash Flows (400,000) (80,000) 1-0.30 70,000 1-0.30 (28,000) 50,000 80,000

Flows Years Amount Cost of new equipment Now (400,000) Working capital needed Now (80,000) Net annual cash receipts 1- 8 100,000 Equipment repairs 4 (40,000) Salvage value of equipment 8 50,000 Release of working capital 8 80,000 Subtotal Present value of CCA tax shield: PV= 400,000 x .2 x .3 x 1.05 50,000 x .2 x .3 .2 + .10 1.10 .2 + .10 = 80,000 x 0.955 - (10,000 x 0.463) Net present value

x

(1 + .10)

10% Present Factor Value 1.000 (400,000) 1.000 (80,000) 5.335 373,450 0.683 (19,124) 0.467 23,350 0.467 37,360 (64,964)

-8

71,734

Finally, calculate the PV of the CCA tax shield adjusted for the salvage value at end of eight year © McGraw-Hill Ryerson Limited., 2001

15-41

Capital Budgeting and Taxes After-Tax Tax Effect Cash Flows (400,000) (80,000) 1-0.30 70,000 1-0.30 (28,000) 50,000 80,000

Flows Years Amount Cost of new equipment Now (400,000) Working capital needed Now (80,000) Net annual cash receipts 1- 8 100,000 Equipment repairs 4 (40,000) Salvage value of equipment 8 50,000 Release of working capital 8 80,000 Subtotal Present value of CCA tax shield: PV= 400,000 x .2 x .3 x 1.05 50,000 x .2 x .3 .2 + .10 1.10 .2 + .10 = 80,000 x 0.955 - (10,000 x 0.463) Net present value

x

(1 + .10)

10% Present Factor Value 1.000 (400,000) 1.000 (80,000) 5.335 373,450 0.683 (19,124) 0.467 23,350 0.467 37,360 (64,964)

-8

71,734 6,770

Since the net present value is positive, the Martin Company should buy the equipment © McGraw-Hill Ryerson Limited., 2001

Appendix

15A Risk and Uncertainty in Capital Budgeting

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A Statistical Measure of Risk Standard Deviation measures the extent actual returns deviate from expected returns. Coefficient of Variation (CV) measures the relative risk of an investment project. Correlation is a statistical technique that measures the relationship of the returns of the project to those of another. Sensitivity Analysis provides management with insight into the effects of changes in variables such as cash flow estimates and discount rates. © McGraw-Hill Ryerson Limited., 2001

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End of Chapter 15

© McGraw-Hill Ryerson Limited., 2001