0804--01 by xiaoyounan

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									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                              1/1/1997            1997              1998             1999

                                           ($50,000)
             Investment in project ..............................................
             Operating cash flows --
                                                                $60,000            $60,000            $60,000
                Revenues ....................................................................................................................
                                                                (30,000) (30,000) (30,000)
                Variable costs ..............................................................................................................
                                                                 (15,000) (15,000) (15,000)
                Fixed costs .................................................................................................
                                                                  15,000             15,000
                Operating CF -- net ................................................................15,000
             Disposal of equipment ..............................                                        20,000

                                         ($50,000) $15,000
             Project net cash flows ..........................                        $15,000           $35,000



Operating    In general, it is usually assumed in capital budgeting that expected
cash flows   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                              1/1/1997             1997              1998              1999

                                           ($50,000)
               Investment in project ..............................................
               Operating cash flows (1) --
                                                                    $60,000            $60,000            $60,000
                    Revenues ....................................................................................................................
                                                                   (30,000) (30,000) (30,000)
                    Variable costs ..............................................................................................................
                                                                   (15,000) (15,000) (15,000)
                  Fixed costs .................................................................................................
                                                                    12,000             12,000
                  Add depreciation ......................................................                  12,000
                                                                    27,000             27,000
                  Operating CF -- net ................................................................27,000
               Disposal of equipment ..............................                                        20,000

                                           ($50,000) $27,000
               Project net cash flows ..........................                          $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                              1/1/1997             1997              1998               1999

                               ($50,000)
Investment in project ..............................................
Operating cash flows --
                                                    $60,000            $60,000            $60,000
  Revenues ....................................................................................................................
                                                    (30,000) (30,000) (30,000)
  Variable costs ..............................................................................................................
                                                    (15,000) (15,000) (15,000)
  Fixed costs (w/ depr) .................................................................................................
                                                      15,000             15,000             15,000
  Profit before taxes ...............................................................................................
  Income taxes @ 34% ............................     (5,100)             (5,100)            (5,100)
                                                          9,900               9,900              9,900
   Total -- net ...........................................................................................
                                                  12,000             12,000
  Add depreciation ......................................................             12,000
                                                  21,900             21,900           21,900
  Operating cash flows ..................................................................................
Disposal of equipment ..............................                                  20,000


                            ($50,000) $21,900
Project net cash flows ..........................                          $21,900           $41,900


Computation of terminal cash flow


Cash flow
                                                                                 $23,091
   Cash proceeds from sale of equipment ..........................................................
                                                                                    (3,091)
   Less applicable income taxes ...................................................................................
                                                                                 $20,000
   Cash proceeds -- net of tax .............................................................................


Taxable gain (loss) and applicable income taxes
                                                                                      $23,091
   Cash proceeds from sale of equipment ..........................................................       $23,091
   Less adjusted tax basis of equipment:
                                                                   $50,000
      Original cost .........................................................................................................
                                                                     (36,000)
         Accumulated depreciation ..............................................................................................
                                                                                        (14,000)
         Adjusted tax basis of equipment .......................................................................................
                                                                                           9,091
     Taxable gain (loss) ...................................................................................
                                                                                              34%
     Effective income tax rate .................................................................................
                                                                                         $3,091              (3,091)
     Applicable income taxes ...................................................................................

                                                                               $20,000
     Cash proceeds from sale of equipment (net of applicable taxes) ..............................
NPV comparison                                       NPV@5% 1/1/1997                    1997         1998      1999


                                                     $7,739 ($50,000) $15,000
    No depreciation, no taxes ..................................................................     $15,000   $35,000


                                                  $38,861 ($50,000) $27,000
    With depreciation, no taxes ..................................................................   $27,000   $47,000


                                                  $25,634 ($50,000) $21,900
    With depreciation and taxes ..................................................................   $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
nt as depreciation generally represents the primary
erating cash flows and terminal cash flows for a given project


s relevant to NPV analyses when tax effects are considered.

								
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