Topic 8: Capital Budgeting

Question 1

What is the process of capital budgeting for analyzing and selecting projects?

Answer 1

Forecasting Cash Flows: Analyze the effects of the project on the firm’s cash flows.

Incremental Earnings: Forecast the project’s impact on the firm’s earnings (incremental earnings of a project).

Free Cash Flows (FCFs): Adjust forecasted incremental earnings to find forecasted FCFs.

Project NPV: Calculate the project’s NPV by discounting expected FCFs at the cost of capital.

Financing Assumption: Assume all equity-financing (ignoring the effects of how a project is financed).

Question 2

What are the two important rules of forecasting earnings and cash flows?

Answer 2

Incremental Cash Flows: Only (and all) cash flows incremental to the particular project should be considered. Incremental cash flows are those that would not occur if the project is not taken on.

Sunk Costs: Sunk costs must be ignored. Sunk costs represent unrecoverable expenditures incurred before the present decision at hand. They are not incremental and are costs already incurred.

Question 3

What are the common incremental items to consider when forecasting earnings and cash flows for a project?

Answer 3

Incremental revenues and costs

Incremental taxes

Incremental capital expenditure

Incremental investments in net working capital

Incremental CCA (Capital Cost Allowance) tax shield

Opportunity costs of utilized resources

Project externalities (e.g., cannibalization of other sales, incremental sales from complementary products, etc.)

Salvage value

Question 4

How is Net Working Capital (NWC) calculated?

Answer 4

Net Working Capital (NWC) = Current Assets - Current Liabilities = Cash + Inventory + Receivables - Payables

Question 5

Why must taxable income (or at least an estimate) be calculated for capital budgeting?

Answer 5

Since corporate income tax is a cash outflow, taxable income (or at least an estimate) must be calculated for capital budgeting to determine the tax implications and cash flow impact.

Question 6

What are the three salvage value scenarios when an asset is sold?

Answer 6

Sell asset for less than remaining UCC

Sell asset for an amount between the original cost and remaining UCC

Sell asset for more than the original cost (capital gain)

Question 7

What are the two approaches to calculating the impact of Capital Cost Allowance (CCA) on the NPV of a project?

Answer 7

1. Calculate CCA for each year of the project and deduct CCA from earnings before tax.
2. Calculate the overall Present Value (PV) from the CCA tax shield separately from the free cash flow forecast.

Question 8

What considerations are there for salvage value when an asset is sold at the end of a project?

Answer 8

Include the proceeds on disposal when forecasting Free Cash Flow (FCF).

If the proceeds exceed the original cost, calculate capital gains tax.

If the proceeds are less than the original cost, a capital loss occurs but is not deductible.

Question 9

Why is a firm not allowed to deduct capital losses on depreciable assets on its tax return?

Answer 9

The lesser of cost and proceeds gets removed from the Undepreciated Capital Cost (UCC) of the particular CCA class, leaving the firm with residual UCC to amortize and claim in future tax years.

Exception: If the asset sold was the only asset left in the particular CCA class, the firm can claim any remaining UCC (after removing the proceeds) as a “terminal loss.”

Question 10

What is Opportunity Cost?

Answer 10

The opportunity cost of using a resource is the value that it could have provided in its best alternative use

E.g. If a company uses a space it already owns for a project, there is an opportunity cost because the same space could have been sublet to produce rental income

Question 11

What are the project externalities?

Answer 11

Indirect effects of the project on other activities of the firm

1. Cannibalization: refers to reduced sales by a firm of existing products when it introduces a new product
2. Complementary Products: Products consumers may be more likely to buy because they are buying another different product from the same company; this can result in an incremental increase in sales.

Question 12

What are sunk costs and non-incremental costs?

Answer 12

Sunk Cost: A cost that has already been incurred and must be paid regardless of whether or not the project is taken.

Non-Incremental Costs: Costs not directly attributable to a specific project and should not be included in its analysis if they will be incurred regardless of whether the project is undertaken.

Question 13

Why do firms sometimes forecast FCF over shorter horizons than a project’s life?

Answer 13

Firms sometimes forecast Free Cash Flow (FCF) over shorter horizons than a project’s life to simplify projections. In these cases, they estimate the value of the remaining FCF beyond the forecast period by adding an extra one-time cash flow at the end of the forecast period (the terminal value, or continuation value).

Question 14

What are some reasons a project might require changes in Net Working Capital (NWC)?

Answer 14

The firm may need to hold a minimum cash balance for contingencies or inventories of raw materials or finished goods.

Projects may involve extending credit to customers (receivables) or receiving credit from suppliers (payables).

Question 15

How does a change in Net Working Capital (NWC) affect Free Cash Flow (FCF)?

Answer 15

An increase in NWC leads to a decrease in FCF.

A decrease in NWC leads to an increase in FCF.

Question 16

What is the significant deviation between taxable income and accounting income in capital budgeting?

Answer 16

The most significant deviation is often depreciation vs capital cost allowance (CCA).

Capital expenditures for new equipment are not deducted when calculating taxable income, nor is accounting depreciation.

Instead, the firm deducts a fraction of this amount each year for tax purposes as capital cost allowance.

Question 17

How is taxable income calculated considering CCA?

Answer 17

Taxable Income = EBIT (Earnings Before Interest and Taxes) - CCA (Capital Cost Allowance)

Question 18

What governs the regulation of depreciation for tax purposes?

Answer 18

Depreciation for tax purposes is regulated by government rules (CRA), which specify how much of the capital expenditure can be deducted each year as capital cost allowance.

Question 19

How does the CRA (Canada Revenue Agency) categorize assets for CCA purposes?

Answer 19

The CRA divides assets into classes and specifies the allowable CCA rate for each class. When an asset is bought, its initial cost is added to the undepreciated capital cost (UCC) for the firm’s asset pool.

Question 20

What is the formula for calculating CCA?

Answer 20

CCA = UCC (or cost of capital expenditure) x CCA rate.

Question 21

What is the half-year rule, and how does it affect CCA calculations in the first year?

Answer 21

The half-year rule applies to most CCA classes and allows only half of the otherwise claimable CCA to be deducted in the first year. Year 1: UCC = 0.5 x Capex.

Question 22

What happens to the CCA tax shields if an asset is not sold when a project ends?

Answer 22

If an asset is not sold when a project ends, the CCA tax shields can continue forever.

Question 23

What happens to the UCC when an asset is sold?

Answer 23

If an asset is sold, the lesser of its original cost or the proceeds on the disposal are removed from the UCC of its class.

Question 24

What happens when an asset is sold for less than the remaining UCC?

Answer 24

UCC balance - Proceeds = Remaining UCC

If the asset was the last in its class, the remaining UCC is claimed as a “terminal loss,” which can be subtracted from taxes.

If other assets remain in the class, continue claiming the remaining UCC to benefit from the CCA tax shield.

Question 25

What happens when an asset is sold for an amount between the original cost and the remaining UCC?

Answer 25

UCC balance - Proceeds = Negative value

This is a “recapture” scenario because the proceeds exceed the remaining UCC, increasing taxable income and taxes due to giving up earlier tax savings.

Tax deductions claimed (CCA) were greater than actual depreciation, leading to increased taxes to recapture the earlier tax savings.

Question 26

What happens when an asset is sold for more than the original cost (capital gain)?

Answer 26

Proceeds - Original Cost = Gain on asset disposal

Wipes out UCC.

Similar to recapture but taxed differently (50% of gain is taxable).

The gain on asset disposal increases taxable income, with an inclusion rate of 67% from 50%.

Question 27

How does calculating CCA for each year of the project factor in the CCA tax shield?

Answer 27

Calculate CCA for each year of the project.

Deduct CCA from earnings before tax to factor in the benefit of the CCA tax shield.

Problem: If capital assets are not sold for at least their original cost, additional CCA tax shields after the project ends may be missed in the cash flow forecast used to calculate NPV.

Question 28

How does calculating the overall PV from the CCA tax shield separately work?

Answer 28

Calculate the overall Present Value (PV) from the CCA tax shield separately from the free cash flow forecast.

Use the PV CCA tax shield formula.

The formula calculates the PV of lost CCA tax shields from the removal of the lesser of proceeds and cost of remaining UCC upon selling the asset (potential recapture or terminal loss situation).

Question 29

What does the PV CCA tax shield formula calculate?

Answer 29

The PV CCA tax shield formula calculates the PV of lost CCA tax shields from the removal of the lesser of proceeds and cost of remaining UCC upon selling the asset, addressing potential recapture or terminal loss situations.

Question 30

How is capital gains tax calculated if the proceeds of an asset exceed its original cost?

Answer 30

Capital Gains Tax
= 2/3 × (Proceeds−CAPEX) × 𝑡𝑐

Question 31

What happens if the proceeds of an asset are less than its original cost?

Answer 31

If the proceeds are less than the original cost, a capital loss occurs. However, the firm is not allowed to deduct capital losses on depreciable assets on its tax return.

Question 32

How do overhead expenses relate to sunk and non-incremental costs?`

Answer 32

Overhead expenses affect many different parts of a firm but are not directly attributable to a particular business activity. If these overhead costs are fixed and will be incurred regardless of whether the project is taken, they are not incremental to the project and should not be included in its analysis.

Question 33

When should lost sales due to cannibalization be ignored in project analysis?

Answer 33

Lost sales due to cannibalization should be ignored if those sales would have been lost to new products from competitors anyway. This means the sales are not truly incremental to the project under consideration.

Question 34

How is the Present Value (PV) of the terminal value calculated?

Answer 34

𝑃𝑉(TerminalValue)
=𝐹𝐶𝐹𝑛+1/(𝑟𝑤𝑎𝑐𝑐−𝑔𝐹𝐶𝐹)/(1+𝑟𝑤𝑎𝑐𝑐)^n

(Aka - growing perpetuity)