Topic 9: Making Capital Investment decisions II

Question 1

Depreciation Tax Shield (Definition and formula)

Answer 1

The tax savings that result from the depreciation deduction.

Calculation: Depreciation multiplied by the corporation tax rate

Depreciation * T

Where:
T = Corporate tax rate

Question 2

Operating Cash flow (The tax shield approach Formula)

Answer 2

OCF = (Sales - Costs) X (1 - T) + Depreciation x T

Where:
T = Corporate Tax

Note: Check example in notes
Note: All three methods should give the same answer

Question 3

Operating cash flow calculation (Bottom-Up approach)

Answer 3

OCF = Net income + Depreciation

(Starts from the bottom of the income statement i.e. Net Income)

Note: Check example in notes
Note: All three methods should give the same answer

Question 4

Operating cash flow calculation (Top-down approach)

Answer 4

Top-down OCF = Sales - Costs - Tax

Note: Check example in notes
Note: All three methods should give the same answer

Question 5

Setting/calculating a Bid Price using NPV (Steps)

Answer 5

We worked ‘bottom-up’ through the key investment steps:

1) Assumed NPV = 0 to set the lowest bid price

2) Found the present value of the investment flows

3) Found the operating cash flows using the annuity factor

4) Adjusted operating cash flow for depreciation to find net income. You will need to calculate depreciation seperately.

5) Using the pro-forma financial statement ‘bottom-up’ to calculate sales revenue and the bid price

Note: Check example in notes

Question 6

Evaluating a cost cutting proposal (Steps)

Answer 6

Key point to remember: need to incorporate incremental cash flows as well as the savings.

incremental cash flows typically include depreciation and tax

The process for evaluating cost savings is a three-step process:

1) Calculate the deprecation charge

2) Calculate net income (After tax) and operating cash flows for each year

3) Calculate the NPV of the project cash flows

Note: Check example in notes

Question 7

Evaluating a cost cutting proposal (Steps)

Answer 7

1) Calculate the depreciation charge

2) Calculate the net income (after tax) and operating cash flows for each year

3) Calculate the NPV of the project cash flows

Note: Check example in notes

Question 8

Equivalent Annual cost (EAC)

Answer 8

The present value of a project’s costs calculated on an annual basis.

Note: If project lives are the same the NPV can be used to make comparisons between multiple projects.

If investments have unequal lives then EAC can provide a more meaningful comparison.

Equivalent annual cost = Net present value / relevant annuity factor

Keep in mind assumptions: alternatives under evaluation must have different economic lives and the alternatives will be needed indefinitely.