Investment projects such as a major year-round

destination resort require managers to consider

several dimensions of the decision including
tourism trends, economic cycles, the environ-
ment, and, ultimately, discounted cash flows.
One of the key considerations is the effect on
cash of tax paid when investments are made in
projects of this type.
Intrawest Corporation has developed
year-round destination resorts such as Whistler-
Blackcomb in British Columbia and Mont
Tremblant in Quebec, pictured above, at costs
exceeding $200 million.
22
Capital
Budgeting:
A Closer Look
C h a p t e r
T
he Income War Tax Act became legislation in 1917 and this
was the first time in Canadas history that the federal
government was given the legal right to tax income. In 1942,
automatic deduction at source began. In 1946 the Income Tax
Appeal Board was born and by 1983 it became the Tax Court of
Canada although it was 1993 before this court achieved sole
jurisdiction over income tax appeals processes. Today Canadian
federal and most provincial governments also impose sales taxes
and value-added taxes (GST and PST), corporate surtax (a per-
centage of tax paid), land transfer tax, and large corporations tax.
Our discussion, however, will be confined to the effect of capital
cost allowance (CCA) on cash paid in corporate income tax. Tax
and inflation are considered external factors affecting corporate
decisions to undertake investment projects because no single
corporation can initiate or change either the rate of taxation or
the rate of inflation. This chapter examines how managers ana-
lyze the financial effects of income taxes and changing prices in
capital budgeting. We discuss risk and uncertainty in capital
budgeting, capital budgeting in not-for-profit organizations, and
issues in implementing the net present value and the internal
rate-of-return decision methods.
L e a r ni ng Ob j e c t i v e s
After studying this chapter, you should be able to
1. Analyze the impact of income taxes on operating
cash flows
2. Analyze the effect of income taxes on capital cash
flows and compute the after-tax net present values
of projects
3. Explain the after-tax effect on cash of tradeins and
disposals of assets
4. Distinguish between the total-project approach
and the differential approach in capital budgeting
decisions
5. Distinguish between the real rate of return and the
nominal rate of return
6. Describe two internally consistent ways to account
for inflation in capital budgeting
7. Describe alternative approaches used to recognize
the degree of risk in capital budgeting projects
8. Explain the excess present value index and its
usefulness in capital budgeting
9. Explain why the internal rate-of-return and the
net present value decision rules may rank projects
differently
Cost Accounting: A Managerial Emphasis, Fourth Canadian Edition
Author: Horngren et al
This material is reproduced with the permission of Pearson Education
Canada.
General Characteristics
Income taxes are cash disbursements and therefore an important cash flow consid-
eration. Income taxes almost always influence the amount and/or the timing of cash
flows. Their basic role in capital budgeting is no different from that of any other
cash disbursement. Payment of income tax tends to narrow the cash differences
between projects.
The Canadian federal and provincial governments raise money through corpo-
rate income taxes. Income tax rates differ considerably, and thus, overall corporate
income tax rates can vary widely.
Income tax rates also depend on the amount of pretax income. Larger income
is taxed at higher rates. In capital budgeting, the relevant rate is the marginal
income tax rate, that is, the tax rate paid on additional amounts of pretax income.
Suppose corporations pay income taxes of 15% on the first $50,000 of pretax income
and 30% on pretax income over $50,000. What is the marginal income tax rate of a
company with $75,000 of pretax income? It is 30%, because 30% of any additional
income over $50,000 will be paid in taxes. In contrast, the companys average income
tax rate is only 20% (i.e., 15% $50,000 30%$25,000 $15,000 $75,000
of pretax income). When we assess tax effects of capital budgeting decisions, we will
always use the marginal tax rate. Why? Because that is the rate applied to the addi-
tional cash flows generated by a proposed project.
Organizations that pay income taxes report their net income to the public
using the CICA standards as they must in order to obtain a clean audit opinion.
These standards allow managers to choose among amortization methods and when
necessary change from one method to another. The amortization expense deducted
would affect taxable income, something the Canadian Revenue Agency (CRA) does
not permit. This is why governments have created laws that, for purposes of paying
tax, require corporations to deduct capital cost allowance (CCA) when calculating
their taxable income. Legally, the taxable income reported to CRA on a confidential
basis differs from mandatory public disclosure under CICA standards. This means
that the tax expense on the statement of income, an accrual, will differ from the cash
tax paid to the government. The difference between the accrual and the cash flow
amounts accumulates as future tax liabilities, which will eventually be paid. This
means that the CCA that affects cash flow in the form of corporate income tax
paid each year is relevant to assessing investment projects. Amortization, however,
is not. In this chapter we are concerned with effects on the cash outflows for
taxes. Therefore, we focus on the tax reporting rules, not those for public financial
reporting.
848 CHAPTER 22
Income Taxes and Capital Budgeting
Marginal income tax rate. The tax
rate paid on any additional amounts
of pretax income.
Department of Finance Canada
Glossary
www.fin.gc.ca/gloss/
gloss-s_e.html
Tax Impact on Operating Cash Flows
Recognizing the impact of income taxes on operating cash flows is straightforward.
If a capital proposal results in a reduction in costs, for example, an annual cost
saving of $60,000, then the companys taxable income will increase by $60,000
all other things being equal. If the company has a marginal tax rate of 40%, then
the companys income taxes will increase by $24,000 ($60,000 0.40). A net
annual after-tax savings of $36,000 results ($60,000 $24,000). This means the
after-tax savings can be calculated quickly as $60,000 (1 minus the tax rate) or
$60,000 0.60 $36,000.
If operating expenses increase by $250,000, then the taxable income will
decrease by $250,000. If the company has a 40% marginal tax rate, then the
tax saving will be $100,000 ($250,000 0.40). An after-tax cost increase
of $150,000 results [$250,000 (1 0.40)]. Thus, to incorporate the impact of
income taxes on operating cash flows poses no real difficulty. The difficulty
occurs in the recognition of the tax effects of investment expenditures in capital
equipment.
O B J E C T I V E 1
Analyze the impact of
income taxes on operating
cash flows
In financial reporting, the expenditure on capital equipment results in the recording
of the asset and the related amortization expense over the assets useful economic
life. Amortization rates and policies are determined by the companys management
and vary from company to company even for the same asset.
To apply a consistent set of regulations and to provide a means to implement
government initiatives, the federal government has implemented its own system of
capital cost allowance (CCA). The Income Tax Act (ITA) does not permit a com-
pany to deduct amortization expense in determining taxable income but rather a
company is allowed to deduct CCA. If you like, CCA is the legally required income
tax counterpart to annual amortization expense in financial reporting.
Capital Cost AllowanceDeclining Balance Classes
The ITA assigns all capital purchases to a CCA class. (The appendix to this chapter
provides a list of some of the more commonly used CCA classes.) For example, a desk
would qualify as a Class 8 asset that includes all furniture and fixtures. Class 8 has a
predetermined rate of 20% declining balance capital cost allowance. Exhibit 22-1 on
page 850 depicts the calculation of CCA for a desk that costs $10,000.
A number of years ago, a company could deduct a full years worth of CCA on
any asset acquired during the year, as long as the company had been in business the
entire year. Thus, companies with a December 31 year-end would buy assets on or
about December 31 and claim a full years deduction even though the asset had not
really been used to generate the income. To minimize this problem, the government
implemented the so-called half-year rule.
The half-year rule assumes that all net additions are purchased in the middle
of the year, and thus only one-half of the stated CCA rate is allowed in the first year.
Thus in year 1 of the example in Exhibit 22-1, the CCA is $1,000 or 1/2 times 20%
multiplied by the $10,000 capital expenditure. This leaves a balance of $9,000
($10,000 $1,000), which is known as the unamortized capital cost (UCC).
In year 2 and all succeeding years, the rate of 20% is applied to the UCC of the
previous year. This results in a declining amount of capital cost allowance for each
year. Even after the 25 years shown in Exhibit 22-1, a UCC of $42 remains and will
require 15 more years to get to a zero balance (which in practice can only be
obtained by rounding to the nearest dollar).
The CCA of each year is deducted in the calculation of a companys taxable
income. Thus, the CCA is not a cash flow. Rather we must multiply the CCA of each
year by the companys marginal tax rate to calculate the actual tax savings in each
year. In Chapter 21, we recognized the time value of money. Thus, to determine the
present value of the tax savings, we would need to multiply the tax savings of each
year by the present value factor from Appendix A for each year at the companys
required rate of return (say 10%).
This, as you could well imagine, would be a long and laborious task to perform
for each capital proposal. An efficient way to calculate the present value of the tax
savings is to use the following tax shield formula:

( ) ( )
In the case of the $10,000 desk, the present value of the tax savings from deducting
CCA, commonly referred to as the tax shield, is $2,548, computed as follows assuming a
10% required rate of return:
Tax shield ($10,000 40%)
( ) ( )
$4,000 0.667 0.955
$2,668 0.955
$2,548
2 10%)
2(1 10%)
20%
20% 10%
(2 required rate of return)
2 (1 required rate of return)
CCA rate
CCA rate required
rate of return
Investment
marginal tax rate
Present value
of tax savings
849
CAPITAL BUDGETING:
A CLOSER LOOK
Tax Impact on Investment Cash Flows
O B J E C T I V E 2
Analyze the effect of income
taxes on capital cash flows
and compute the after-tax
net present values of projects
Capital cost allowance (CCA).
The legally mandatory income tax
counterpart to annual amortization
expense in financial reporting.
Half-year rule. The assumption, in
calculating capital cost allowance,
that all net additions to a companys
assets are purchased in the middle
of the year, so that only half the
applicable capital cost allowance
rate is allowed in the first year.
Unamortized capital cost (UCC).
The result of subtracting the capital
cost allowance from the capital
expenditure or its amortized balance.
Tax shield formula. A formula for
calculating the tax savings from
deducting capital cost allowance.
Therefore, the net after-tax cost of the desk is $7,452, or $10,000 less $2,548.
A detailed proof of the tax shield formula is not necessary for our purposes, but
some explanation will be useful. The first component of the formula, investment
times the marginal tax rate, computes the total tax savings over the life of the asset
from the CCA deduction. The $4,000, however, does not incorporate any time value
of money considerations.
The second component, the CCA rate divided by the sum of the CCA rate plus
the required rate of return, calculates the present values of all the annual tax savings
assuming the half-year rule did not exist. This is important to note when residual
values are discussed later in the chapter.
The third component incorporates an adjustment for the half-year rule. For
example, in the above scenario, the tax shield was reduced to 95.5% of the benefit
that existed before the introduction of the half-year rule.
Capital Cost AllowanceOther Classes
Most CCA classes use the declining balance method. However, occasionally the
straight-line method is used in which the CCA is the same for each year, except for
the first and last years, which have one-half of the CCA due to the half-year rule. It
is also important to note that CCA applies only to tangible assets. The income tax
statutes for intangible assets such as patents, copyrights, and trademarks differ as
does the terminology. The statutory deduction is based on 75% of the acquisition
850 CHAPTER 22
EXHIBIT 22-1
Capital Cost Allowance Illustration
CCAClass 8
Rate is 20% Declining Balance
(rounded to the nearest dollar)
Year 1 (day 1) addition $10,000
CCA year 1 (10%) 1,000
Year end UCC 9,000
CCA year 2 (20%) 1,800
Year 2 UCC 7,200
CCA year 3 (20%) 1,440
Year 3 UCC 5,760
CCA year 4 (20%) 1,152
Year 4 UCC 4,608
CCA year 5 (20%) 922
Year 5 UCC 3,686
CCA year 6 (20%) 737
Year 6 UCC 2,949
CCA year 7 (20%) 590
Year 7 UCC 2,359
CCA year 8 (20%) 472
Year 8 UCC 1,887
CCA year 9 (20%) 377
Year 9 UCC 1,510
CCA year 10 (20%) 302
Year 10 UCC 1,208
CCA year 11 (20%) 242
Year 11 UCC 966
CCA year 12 (20%) 193
Year 12 UCC 773
CCA year 12 (20%) 155
Year 13 UCC 618
CCA year 14 (20%) 124
Year 14 UCC 494
CCA year 15 (20%) 99
Year 15 UCC 395
CCA year 16 (20%) 79
Year 16 UCC 316
CCA year 17 (20%) 63
Year 17 UCC 253
CCA year 18 (20%) 51
Year 18 UCC 202
CCA year 19 (20%) 40
Year 19 UCC 162
CCA year 20 (20%) 32
Year 20 UCC 130
CCA year 21 (20%) 26
Year 21 UCC 104
CCA year 22 (20%) 21
Year 22 UCC 83
CCA year 23 (20%) 17
Year 23 UCC 66
CCA year 24 (20%) 13
Year 24 UCC 53
CCA year 25 (20%) 11
Year 25 UCC $42
cost of the intangible asset. This is termed the eligible capital property. Intangible
assets, by definition, have an indefinite useful life, and the annual deduction is called
the cumulative eligible capital amount (CECA), calculated at 7% on a declining-
balance basis. The balance remaining after deducting CECA is called the cumula-
tive eligible capital (CEC) pool.
Tradeins and Disposals of Capital Assets
When a capital asset is traded in on another asset or is sold, we do not need to concern
ourselves with the net tax book value of the asset.
Assume that a companys Class 8 UCC for all of its furniture and fixtures is
$50,000, as shown in Exhibit 22-2, at the end of year 3. Let us also assume that included
in the $50,000 is the remaining UCC on the desk of $5,760.
If in year 4 the desk was traded in on a new desk, where the price of the new
desk is $12,000, and $4,000 was allowed as a tradein, the Class 8 UCC would increase
by $8,000. Note that the CCA system works on a pool basis, in that we are not con-
cerned with the UCC of the specific desk being sold. Rather we are only concerned
with the net cash flows. The UCC of the class that existed before the disposal is only
reduced by the amount of the cash received. Thus, the actual amount of the UCC of
the specific asset is irrelevant to the decision. In this example, the net capital expen-
diture of $8,000 is the relevant cash flow.
Continuing with the example in Exhibit 22-2, the CCA for year 4 is $10,800.
This is a combination of the CCA at the rate of 20% on the opening UCC of
$50,000 ($10,000) and the CCA at the half-year rule rate of 10% on the net addition
of $8,000 ($800).
Thus, as shown in Exhibit 22-3 on page 852, the net after-tax present value of
the cost of the new desk is $5,964. This amount recognizes the fact that the tax
shield of $2,036 on the net addition of $8,000 must recognize the half-year rule.
If in the above scenario a new desk had not been purchased, but rather the old
desk was sold for $4,000, the CCA would be 20% of $46,000 or $9,200. Note the
half-year rule does not apply to net disposals, that is where the amount of disposals
exceeds the amount of additions during a given year.
From Exhibit 22-3, note that the sale of $4,000 reduces the future CCA and results
in a lost tax shield of $1,067. Thus, the net after-tax present value of the sale is $2,933.
Simplifying Assumptions
It is useful to note that a number of simplifying assumptions have been made when
using the tax shield formula:
1. We have assumed that the companys marginal tax rate will remain the same (at
40% in the above examples). Further, the above examples also assume that the
company will have a taxable income each year.
851
CAPITAL BUDGETING:
A CLOSER LOOK
Eligible capital property. 75% of
the acquisition cost of an intangible
asset, and the basis for the annual
deduction permitted by the income
tax act.
Cumulative eligible capital
amount (CECA). The statutory
annual deduction permitted on
intangible assets; the equivalent
of CCA for tangible assets.
Cumulative eligible capital (CEC).
The balance remaining after
deducting CECA; the equivalent of
UCC for tangible assets.
Department of Justice, Canada
http://laws.justice.gc.ca/en/
I-3.3/C.R.C.-c.945/135982.html
O B J E C T I V E 3
Explain the after-tax effect
on cash of tradeins and
disposals of assets
EXHIBIT 22-2
Tradein of a Capital Asset
CCAClass 8
Ending UCCyear 3 50,000 $
Purchase 12,000
Year 4CCA
20% $50,000 10,000
Total CCA 10,800
Less: Tradein (4,000)
Net change in UCC 8,000
Revised UCC 58,000
10% $8,000 800
$ UCCyear 4 47,200
2. Although it is uncommon, governments can change the CCA rates that we
have assumed to be constant.
3. We have also assumed that all CCA tax savings occur at the year-end. In reality,
companies make monthly instalments. However, the additional cost of
attempting to be more precise is not warranted, given the degree of uncertainty
that already exists in the estimation of the cash flows.
852 CHAPTER 22
EXHIBIT 22-3
Net Capital Cash Flow of Tradeins and Disposals
Tradein (4,000)
Net cash payment 8,000
Tax shield
a
2,036
NPV cash outflow 5,964 $
Disposal:
Sales price 4,000
Lost tax shield
b
1,067
NPV cash inflow 2,933 $
a
Includes the half-year adjustment:
($8,000 40%)

b
Excludes the half-year adjustment
($4,000 40%)
Purchase price 12,000 $ Tradein:
20%10%
20%10%
20%
2(110%)
210%
20%
In the foregoing illustrations, we deliberately avoided many possible income tax
complications. As all taxpaying citizens know, income taxes are affected by many
intricacies, including progressive tax rates, loss carrybacks and carryforwards, vary-
ing provincial income taxes, capital gains, distinctions between capital assets and
other assets, offsets of losses against related gains, exchanges of property of like kind,
exempt income, and so forth.
Income Tax Complications
Confusion About Amortization
Keep in mind that changes in the tax law occur each year. Always check the current
tax law before calculating the tax consequences of a decision.
The meanings of amortization and book value are widely misunderstood.
Pause and consider their role in decisions. Suppose a bank has some printing equip-
ment with a book value of $30,000, an expected terminal disposal value of zero, a
current disposal value of $12,000, and a remaining useful life of three years. For sim-
plicity, assume that straight-line amortization of $10,000 yearly will be taken.
In particular, note that the inputs to the decision model are the predicted
income tax effects on cash. The book loss of $18,000 or the amortization of $10,000
may be necessary for making predictions. By themselves, however, they are not inputs
to DCF decision models.
The following points summarize the role of amortization regarding the
replacement of equipment:
1. Initial investment. The amount paid for (and hence amortization on) old equip-
ment is irrelevant except for its effect on tax cash flows. In contrast, the amount
paid for new equipment is relevant, because it is an expected future cost that will
not be incurred if replacement is rejected.
2. Do not double-count. The investment in equipment is a one-time outlay at time
zero, so it should not be double-counted as an outlay in the form of amortization.
Amortization by itself is irrelevant; it is not a cash outlay.
3. Relation to income tax cash flows. Relevant quantities were defined in Chapter 4
as expected future data that will differ among alternatives. Given this definition,
book values and past amortization are irrelevant in all capital budgeting decision
models. The relevant item is the income tax cash effect, not the book value or the
amortization.
853
CAPITAL BUDGETING:
A CLOSER LOOK
Alternative Approaches to Capital Budgeting
We turn now to a fuller discussion of how income taxes can affect cash inflows and out-
flows and also how they influence managers decisions. We focus on the information-
acquisition and selection stages of capital budgeting, highlight the effect of income
taxes, and use the net present value method for the formal financial analysis.
Example: Potato Supreme produces potato products for sale to supermarkets and
other retail outlets. It is considering replacing an old packaging machine (purchased
three years ago) with a new, more efficient packaging machine that has recently been
introduced. The new machine is less labour-intensive and has lower operating costs
than the old machine. For simplicity, we assume that
1. All cash outflows or inflows occur at the end of the year (even though cash
operating costs generally occur throughout the year).
2. The tax effects of cash inflows and outflows occur at the same time that the
inflows and outflows occur.
3. The income tax rate is 30% each year.
4. The equipment is one of several assets that qualify as CCA Class 8, with a CCA
rate of up to 20% declining balance. Potato Supreme takes the maximum rate
each year.
5. Both the old and the new machine have the same working capital requirements.
6. Potato Supreme is a profitable company.
Summary data for the two machines are as follows:
Old Machine New Machine
Original cost $ 87,500 $200,000
Accumulated amortization $ 37,500
Current book value $ 50,000
Current disposal price $ 26,000
Proceeds of disposition, 4 years from now $ 6,000 $ 20,000
Annual cash operating costs $250,000 $150,000
Remaining useful life 4 years 4 years
After-tax required rate of return 10% 10%
Capital cost allowance rate 20% (declining 20% (declining
balance) balance)
Potato Supreme uses the net present value method to evaluate whether it should
replace the old with the new packaging machine immediately or in four years time.
As in the Lifetime Care example of Chapter 21, the key point in net present value
analysis is to identify the relevant cash flows. To emphasize the ideas of relevance,
Chapter 21 used the differential approach, which analyzes only relevant cash
flowsthose future cash outflows and inflows that differ between alternatives. The
differential approach is generally faster when there are only two alternatives.
When the number of alternatives is more than two, the differential approach
becomes unwieldy. Why? Because it forces the analyst into difficult calculations of
differences among multiple alternatives. Companies then use the total-project approach.
O B J E C T I V E 4
Distinguish between the
total-project approach and
the differential approach in
capital budgeting decisions
Differential approach. Approach to
decision making and capital
budgeting that analyzes only those
future cash outflows and inflows that
differ among alternatives.
The total-project approach calculates the present value of all future cash inflows
and outflows under each alternative separately. It does not require the identification
of cash flows that differ among alternatives. The total-project approach has two steps:
Step 1. Calculate the present value of all cash inflows and outflows under the
status quo alternative.
Step 2. Separately calculate the present value of all cash inflows and outflows
under another alternative.
We use the Potato Supreme example to illustrate the two steps of the total-project
approach. We then use the differential approach to show that both approaches give the
same net present value. The following categories of cash flows are considered in both
approaches:
a. Initial machine investment
b. Tax shield on the initial investment
c. Cash flow from current disposal of old machine
d. Lost tax shield from current disposal of machine
e. Recurring after-tax cash operating flows
f. Cash flow from proceeds of disposition of old machine. Other assets remain
in this asset class.
g. Lost tax shield from terminal disposal of machine
Total-Project Approach
Step 1: Calculate the present value of total cash flows of replacing the old packaging
machine in four years time. Under this alternative, cash flow categories that
specifically pertain to the new machine are not relevant. But the purchase price
is relevant when calculating item g, the lost tax shield. If the purchase price
of new equipment exceeds proceeds of disposition of the old equipment,
net addition, the half-year rule applies.
a. Initial machine investment. No new investment is necessary if Potato Supreme
keeps the old packaging machine. Exhibit 22-4, item a, shows an initial
machine investment of $0 in year 0.
b. Tax shield on initial investment. As there is no new investment, there is then no
additional tax shield.
c. Cash flow from current disposal of old machine. Since the old machine is kept and
not disposed of, Exhibit 22-4, item c, shows after-tax cash flow from current
disposal of old machine of $0 in year 0.
d. Lost tax shield from current disposal of machine. As the old machine is not sold,
no tax shield adjustments are required.
e. Recurring after-tax cash operating flows.
Recurring cash operating flows (costs) for the old machine $(250,000)
Deduct: Income tax savings at 30% of $250,000 75,000
Recurring after-tax cash operating flows $(175,000)
After-tax cash operating flows of $(175,000) in years 1 to 4 appear as relevant
cash outflows in Exhibit 22-4, item e. Our example assumes that Potato
Supremes income tax rate is 30% each year. When future tax rates are uncer-
tain, analysts must predict the tax rate applicable for each year of a project.
f. Cash flow from proceeds of disposition of old machine. Other assets remain in this asset class.
Proceeds of disposition at end of year 4 $6,000
The cash flow of $6,000 from the proceeds of disposition of the old machine
appears as a cash inflow in year 4 of Exhibit 22-4, item f.
g. Lost tax shield. The proceeds of disposition of $6,000 would reduce the CCA
pool by $6,000, and thus reduce the future cash savings from capital cost
allowance deductions by $1,145.
854 CHAPTER 22
Total-project approach. Approach
to decision making that incorporates
all relevant revenues and relevant
costs under each alternative.
In capital budgeting decisions,
calculates the present value of all
future cash inflows and outflows
under each alternative separately.
Net addition. The difference
between the purchase price of the
new equipment and the proceeds
of disposition of the old equipment.
When the purchase price exceeds
the proceeds of disposition the half-
year rule applies when calculating
the lost tax shield; otherwise, the
half-year rule applies.
($6,000 0.30)
$1,800 2 3 0.955 $1,146
Exhibit 22-4 presents all after-tax cash flows that would arise if
Potato Supreme continued to use the old packaging machine. Each cash
flow is multiplied by its corresponding present value discount factor to
give its present value. The total present value is $(551,435).
Step 2: Calculate the present value of total cash flows of immediately replacing the old
packaging machine.
a. Initial machine investment. The original cost of the new packaging machine is
$200,000. This amount appears as a cash outflow in year 0 in Exhibit 22-5,
item a (p. 856).
b. Tax shield. The original cost of $200,000 will generate a cash savings from
capital cost allowance of $38,160. This amount is determined by using the tax
shield formula.
($200,000 0.30)
$60,000
2

3

2.1

2.2
$40,000 0.955 $38,200
Recall that the tax shield formula calculates the present value of the cash flows.
c. Cash flow from immediate proceeds of disposition.
Immediate proceeds of disposition $26,000
Review what is included in the present value analysis. It is the immediate
cash inflow from the proceeds of disposition of the asset. The book value of
the old machine and the loss on disposal do not themselves affect cash flow.
The book value, however, enters into the calculation of the loss on disposal of
the asset, which in turn affects the accounting net income.
2 0.10
2(1 0.10)
0.20
(0.20 0.10)
2 0.10
2(1 0.10)
0.20
(0.20 0.10)
855
CAPITAL BUDGETING:
A CLOSER LOOK
Present
Value
Total Discount
Present Factors
Value at 10%
End of Year: 0 1 2 3 4
Explanations for the after-tax cash flow
amounts are given on pp. 854855.
a. Initial machine investment $ 0 1.000 $0
c. After-tax cash flow from immediate
proceeds of disposition 0 1.000 0
e. Recurring after-tax
cash operating flows (554,750) 3.170 $(175,000) $(175,000) $(175,000) $(175,000)
f. Cash flow from proceeds
of disposition in four years time 4,098 0.683 6,000
g. Lost tax shield from the
disposal in four years time (783) 0.683 ($1,146)
Total present value of all cash
flows if Potato Supreme
replaces the old machine in
four years time $(551,435)
Note: Parentheses denote relevant cash outflows throughout all exhibits in this chapter.
EXHIBIT 22-4
Total-Project Approach for Potato Supreme: After-Tax Analysis of Replacing Old Machine in Four years Time
Sketch of Relevant After-Tax Cash Flows
d. Lost tax shield from immediate disposal of old machine. The current disposal of
$26,000 would reduce the cash savings from future capital cost allowance by
$4,966.
($26,000 0.30)
$7,800
2

3
0.955
$4,966
In this case, the half-year rule applies to the calculation of the tax shield for-
mula because the net addition is a positive number ($200,000$26,000).
e. Recurring after-tax cash operating flows.
Recurring cash operating flows (costs) for the new machine $(150,000)
Deduct: Income tax savings (30% $150,000) 45,000
Recurring after-tax cash operating flows $(105,000)
The after-tax cash operating flows of $(105,000) in years 1 to 4 appear as
relevant cash outflows in Exhibit 22-5, item e.
f. Cash flow from proceeds of disposition of new machine. Other assets remain in this asset
class.
Proceeds from disposition of new machine $20,000
g. Lost tax shield from disposition of new machine in four years time. Assume no future
replacement for the new machine. Therefore, the net addition ($0$20,000) will
be negative and the half-year rule will not apply. The proceeds of disposition
2 0.10
2(1 0.10)
0.20
0.20 0.10
856 CHAPTER 22
EXHIBIT 22-5
Total-Project Approach for Potato Supreme: After-Tax Analysis of Immediately Purchasing the New Machine
Present
Value
Total Discount
Present Factors
Value at 10%
End of Year: 0 1 2 3 4
Explanations for the after-tax
cash flow amounts
are given on pp. 855 and 856.
a. Initial machine investment $(200,000) 1.000 $(200,000)
b. Tax shield 38,200 1.000 $ 38,200
$(161,800)
c. Cash flow from immediate
proceeds of disposition
of old machine 26,000 1.000 $ 26,000
d. Lost tax shield from immediate
disposal of old machine $ (4,966) 1.000 $ (4,966)
Net investment $(140,766)
e. Recurring after-tax
cash operating flows (332,850) 3.170 $(105,000) $(105,000) $(105,000) $(105,000)
f. Cash flow from proceeds of
disposition of the new machine
in four years time disposal of
new machine 13,660 0.683 $20,000
g. Lost tax shield from disposal of the
new machine in four years time (2,732) 0.683 (4.000)
Total present value of all cash flows
if Potato Supreme immediately
replaces the old machine $(462,688)
Sketch of Relevant After-Tax Cash Flows
of $20,000 would reduce the future cash savings from CCA at the maximum
rate of 20% by $2,732.
($20,000 0.30)
$6,000
2

3
$4,000
Exhibit 22-5 summarizes the relevant after-tax cash flows that would occur if
Potato Supreme replaced its old machine immediately. Present values are derived by
multiplying cash flows by the corresponding present value discount factors. The
total present value of cash flows equals $(462,688). Recall from Exhibit 22-4 that the
present value of after-tax cash flows of replacing the old machine in four years time
is $(551,435). The decision to replace the old machine with the new machine imme-
diately has a positive net present value of $88,747 ($551,435 $462,688) and is
therefore preferred.
Differential Approach
Unlike the two-step total-project approach, the differential approach is a one-step
method that includes only those cash inflows and outflows that differ between the
two alternatives. The differential approach compares the cash outflows arising from
replacing the old machine with the savings in future cash outflows resulting from
using the new machine rather than the old machine. We will now examine the differ-
ences in cash flows between the keep and replace alternatives in the Potato Supreme
example using the categories of cash flows that we described earlier.
0.20
(0.20 0.10)
857
CAPITAL BUDGETING:
A CLOSER LOOK
Present
Value
Total Discount
Present Factors
Value at 10%
End of Year: 0 1 2 3 4
Explanations for the after-tax inflow
amounts are given on pp. 856 and 857.
a. Initial machine investment $(200,000) 1.000 $(200,000)
c. Cash flow from immediate proceeds
of disposition of old machine 26,000 1.000 26,000
Net initial investment (174,000) (174,000)
b. net of d. Tax shield (Exhibit 22-5) 33,234 1.000 33,234
(140,766)
e. Recurring after-tax cash operating flows
221,900 3.170 $70,000 $70,000 $70,000 $70,000
f. Cash flow from proceeds of disposition
of old machine in four years time (4,098) 0.683 $ (6,000)
g. Lost tax shield from disposal
of old machine in four years time 783 0.683 $ 1,146
(3,315)
f. Cash flow from proceeds of disposition
of new machine in four years time
($551,435$462,688) $88,747 13,660 0.683 $20,000
g. Lost tax shield from disposal
of new machine in four
years time (2,732) 0.683 $ (4,000)
10,928
Net present value if old machine is
replaced immediately $ 88,747
EXHIBIT 22-6
Differential Approach for Potato Supreme: After-Tax Analysis of Replacing Old Machine
Sketch of Relevant After-Tax Cash Flows
a. Initial machine investment of $200,000 for the new machine (see Exhibit 22-5)
appears as a cash outflow in year 0 in Exhibit 22-6, item a.
c. Cash flow from immediate proceeds of disposition of old machine of $26,000
(see Exhibit 22-5) appears as a cash inflow in year 0 in Exhibit 22-6, item c.
The initial machine investment, $200,000, minus the cash flow from
current disposal of the old machine, $26,000, is the net initial investment
of $174,000, shown as a cash outflow in year 0 in Exhibit 22-6.
b. net of d. Tax shield. The net initial investment of $174,000 would increase the
CCA pool by this amount and thus would generate cash savings from
CCA from now to infinity. The cash savings would be $33,199, a figure
determined by using the tax shield formula:
($174,000 0.30)
$52,200
2

3
0.955
$33,234
e. Recurring after-tax cash operating flows. Replacing the old machine results
in lower after-tax cash operating costs, as follows:
Recurring after-tax cash operating costs
if old machine kept (Exhibit 22-4, item e) $175,000
Deduct: Recurring after-tax cash operating costs
if machine replaced (Exhibit 22-5, item e) 105,000
Savings in recurring after-tax cash operating costs
if machine replaced $ 70,000
Exhibit 22-6, item e, shows this $70,000 increase in recurring after-tax
cash operating flows in years 14.
f. net of g. Cash flow from proceeds of disposition of each machine in four years time, net of
the lost tax shield of each respective disposal. The immediate disposition of
the old machine results in no disposition of this machine in four years
time. This opportunity cost for the old machine based on Exhibit 22-4 is
$3,315 ($4,098 to $793) for the old machine. The opportunity cost for
the new machine based on Exhibit 22-5 is $10,928 ($13,550$2,732).
In Exhibit 22-5, the terminal disposal of the new machine for $20,000 will result in
a lost tax shield of $2,732, the net of which is $10,928.
Both the total-project approach (Exhibits 22-4 and 22-5) and the differential approach
(Exhibit 22-6) result in a net present value of $88,747 in favour of immediately replacing
the old packaging machine with the new one. When comparing alternatives, these two
approaches will always give the same net present value.
(2 0.10)
2(1 0.10)
0.20
(0.20 0.10)
858 CHAPTER 22
Capital Budgeting and Inflation
Inflation can be defined as the decline in the general purchasing power of the mon-
etary unit (for example, the dollar in Canada or the yen in Japan). An inflation rate of
10% in one year means that what you could buy with $100 (say) at the start of the
year will cost you $110 [$100 (10% $100)] at the end of the year. Prices increase
as more money chases fewer goods. Some countriesfor example, Brazil, Israel,
Mexico, and Russiahave experienced annual inflation rates of 15% to more than
100%. Even an annual inflation rate of 5% over, say, a five-year period can result in
sizable declines in the general purchasing power of the monetary unit over that time.
Why is it important to account for inflation in capital budgeting? Because
declines in the general purchasing power of the monetary unit (say, dollars) will inflate
future cash flows above what they would have been had there been no inflation.
These inflated cash flows will cause the project to look better than it is, unless the
analyst recognizes that the inflated cash flows are measured in dollars that have lesser
value than the dollars that were initially invested. We now examine how inflation can
be explicitly recognized in capital budgeting analysis.
O B J E C T I V E 5
Distinguish between the real
rate of return and the
nominal rate of return
Inflation. The decline in the general
purchasing power of the monetary
unit.
Real and Nominal Rates of Return
When analyzing inflation, distinguish between the real rate of return and the nomi-
nal rate of return:
Real rate of return is the rate of return required to cover only investment risk.
Nominal rate of return is the rate of return required to cover investment risk
and the anticipated decline, due to inflation, in the general purchasing power
of the cash that the investment generates. The rates of return (or interest)
earned on the financial markets are nominal rates, because they compensate
investors for both risk and inflation.
We next describe the relationship between real and nominal rates of return. Assume
that the real rate of return for investments in high-risk cellular data transmission
equipment at Network Communications is 20% and that the expected inflation rate
is 10%. The nominal rate of return
1
is:
Nominal rate (1 Real rate)(1 Inflation rate) 1
(1 0.20)(1 0.10) 1
[(1.20)(1.10)] 1 1.32 1 0.32
The nominal rate of return is also related to the real rate of return and the inflation
rate as follows:
Real rate of return 0.20
Inflation rate 0.10
Combination (0.20 0.10) 0.02
Nominal rate of return 0.32
Note that the nominal rate is slightly higher than the real rate (0.20) plus the
inflation rate (0.10). Why? Because the nominal rate recognizes that inflation also
decreases the purchasing power of the real rate of return earned during the year.
Net Present Value Method and Inflation
The watchwords when incorporating inflation into the net present value (NPV) method
is internal consistency. There are two internally consistent approaches:
Nominal approach. Predict cash inflows and outflows in nominal monetary units
and use a nominal rate as the required rate of return.
Real approach. Predict cash inflows and outflows in real monetary units and use
a real rate as the required rate of return.
Consider an investment that is expected to generate sales of 100 units and a
net cash inflow of $1,000 ($10 per unit) each year for two years absent inflation. If infla-
tion of 10% is expected each year, net cash inflows from the sale of each unit would be
$11 ($10 1.10) in year 1 and $12.10 [$11 1.10 or $10 (1.10)
2
] in year 2 resulting
in net cash inflows of $1,100 in year 1 and $1,210 in year 2. The net cash inflows of
$1,100 and $1,210 are nominal cash inflows because they include the impact of infla-
tion. These are the cash flows recorded by the accounting system. The cash inflows of $1,000
each year are real cash flows because they exclude inflationary effects. Note that the real
cash flows equal the nominal cash flows discounted for inflation, $1,000 $1,100
1.10 $1,210 (1.10)
2
. Many managers find the nominal approach easier to under-
stand and use, because they observe nominal cash flows in their accounting systems and
the nominal rates of return on financial markets.
Lets revisit Network Communications, which is deciding whether to invest in
equipment to make and sell a cellular data transmission product. The equipment
would cost $750,000 immediately. It is expected to have a four-year useful life with a
zero terminal disposal price. An annual inflation rate of 10% is expected over this
859
CAPITAL BUDGETING:
A CLOSER LOOK
Real rate of return. The rate of
return required to cover only
investment risk.
Nominal rate of return. Rate of
return required to cover investment
risk and the anticipated decline due
to inflation in the general purchasing
power of the cash that the
investment generates.
O B J E C T I V E 6
Describe two internally
consistent ways to account
for inflation in capital
budgeting
1
The real rate of return can be expressed in terms of the nominal rate of return as follows:
Real rate 1 1 = 0.20
(1 0.32)
(1 + 0.10)
(1 Nominal rate)
(1 Inflation rate)
four-year period. Network Communications requires an after-tax real rate of return
of 20% from this project or an after-tax nominal rate of return of 32%.
The following table presents the predicted amounts of real (assuming no infla-
tion) and nominal (after considering cumulative inflation) net cash inflows from the
equipment over the next four years (excluding the $750,000 investment in the equip-
ment and before any income tax payments):
Before-Tax Cumulative Before-Tax
Cash Inflows in Inflation Rate Cash Inflows in
Real Dollars Factor
*
Nominal Dollars
Year (1) (2) (3) (1) (2)
1 $500,000 (1.10)
1
1.1000 $550,000
2 600,000 (1.10)
2
1.2100 726,000
3 600,000 (1.10)
3
1.3310 798,600
4 300,000 (1.10)
4
1.4641 439,230
*1.10 1.00 0.10 inflation rate.
The income tax rate is 40%. For tax purposes, the equipment will be amortized
using a capital cost allowance rate of 30%, declining balance method.
Because of inflation, the cash
inflows for future periods will be
measured in dollars that have less value
than the dollars invested in the project
in year 0. Failure to take inflation into
account will overstate the financial
return of the project.
Present Sketch of Relevant After-Tax Cash Flows
Value
Total Discount
Present Factors
Value at 32%

End of Year: 0 1 2 3 4
1. Initial equipment investment:
Investment:
Year Outflows
0 $(750,000)
2. Cash savings from tax shield
3. Recurring after-tax cash operating flows:
Recurring Nominal
Recurring After-Tax
Nominal Income Cash
Cash Tax Operating
Operating Outflows Inflows
Year Inflows (3) (4)
(1) (2) 0.40 (2) (2) (3)
1 $550,000 $220,000 $330,000
2 726,000 290,400 435,600
3 798,600 319,440 479,160
4 439,230 175,692 263,538
Net present value
*The nominal discount rate of 32% is made up of the real rate of interest of 20% and the inflation rate of 10%: [(1 0.20)(1 0.10)] 1 0.32.

Present value discount factors are shown to six decimal digits to emphasize that the approaches to inflation in Exhibits 22-7 and 22-8 are
equivalent. The formula on Table 2 of Appendix A is used to compute the present value discount factor.

$(750,000 0.40)
$300,000 0.484 0.879
$127,631.
2 0.32
2(1 0.32)
0.30
0.30 0.32
$(750,000) 1,000000 $(750,000)
$ 127,631

1,000000 $ 127,631
$(622,369)
250,000 0.757576 $330,000
250,000 0.573921 $435,600
208,333 0.434789 $479,160
86,805 0.329385 $263,538
795,138
$ 172,769
EXHIBIT 22-7
Nominal Approach to Inflation for Network Communications: Predict Cash Inflows and Outflows in Nominal Dollars
and Use a Nominal Discount Rate*
Exhibit 22-7 presents the capital budgeting approach for predicting cash flows in
nominal dollars and using a nominal discount rate.
2
The calculations in Exhibit 22-7
exactly follow the calculations used in the Potato Supreme example for initial machine
investment, tax shields, and recurring after-tax cash operating flows.
Exhibit 22-8 presents the approach of predicting cash flows in real terms and
using a real discount rate. The calculations for item 3, recurring after-tax cash operat-
ing flows, are basically the same as before except that the cash inflows are measured in
real terms and discounted at real rates.
Both approaches show that the project has a net present value of $172,769 and
should therefore be accepted. Why do the two approaches give the same answer?
Because, for example, in going from the real approach to the nominal approach, the
cash flows are multiplied by and the discount rates are divided by the same cumulative
inflation factor.
3
861
CAPITAL BUDGETING:
A CLOSER LOOK
Under the nominal approach, first
express all amounts in terms of
future-year dollars (using cumulative
inflation rate factors), then discount the
resulting amounts to their present value
using nominal discount-rate factors.
2
The present value discount factors in the example are calculated using six decimal digits to eliminate
doubt about the equivalence of the two approaches. In practice, the present value discount factors (to
three decimal digits) can be obtained using Table 2 (present value of $1) of Appendix A at the end of
the text. The Problem for Self-Study at the end of this chapter uses Table 2.
3
For example, recurring after-tax real cash operating flow in year 2 of $360,000 in Exhibit 22-8 is
multiplied by (1.10)
2
to give $435,600 in after-tax nominal cash operating flows in year 2 in
Exhibit 22-7. The real discount rate of 0.694444 in year 2 in Exhibit 22-8 is divided by (1.10)
2
to
give the nominal discount rate of 0.573921 in year 2 in Exhibit 22-7.
Present Sketch of Relevant After-
Value Tax Cash Flows
Total Discount
Present Factors
Value at 20%
*
End of Year:
1. Initial equipment investment:
Investment
Year Outflows
0 $(750,000)
2. Cash savings from tax shield

3. Recurring after-tax cash operating flows:

Recurring
Recurring Real After-
Real Cash Income Tax Cash
Operating Tax Operating
Year Inflows Outflows Inflows
(1) (2) (3) (4)
0.40 (2) (2) (3)
1 $500,000 $200,000 $300,000
2 600,000 240,000 360,000
3 600,000 240,000 360,000
4 300,000 120,000 180,000
Net present value
*
Present value factors are shown to six decimal digits and the present value calculations rounded to emphasize that the approaches to inflation in
Exhibits 22-7 and 22-8 are equivalent. The formula on Table 2 of Appendix A is used to compute the present value discount factor.

The computation of these inflation factors is explained in footnote 3 below.

The tax shield formula has used the nominal rate of 32% for demonstration purposes. It is common for companies to use a nominal rate, even
though capital cost allowance amounts are not inflated.
0 1 2 3 4
$(750,000) 1.000000 $(750,000)
127,631

1.000000 127,631
$(622,369)
250,000 0.833333 $300,000
250,000 0.694444 $360,000
208,333 0.578704 $360,000
86,805 0.482253 $180,000
795,138
$ 172,769
EXHIBIT 22-8
Real Approach to Inflation for Network Communications: Predict Cash Inflows and Outflows in Real Dollars
and Use a Real Discount Rate
The most frequently encountered error when accounting for inflation in capi-
tal budgeting is stating cash inflows and outflows in real monetary units and using a
nominal discount rate. This error understates the discounted present value of cash
flows that occur in the future and therefore creates a bias against the acceptance of
many worthwhile capital investment projects.
862 CHAPTER 22
Project Risk And Required Rate Of Return
The required rate of return (RRR), which we discussed in Chapter 21, is a critical variable
in discounted cash flow analysis. It is the rate of return that the organization forgoes by
investing in a particular project rather than in an alternative project of comparable risk.
Risk here refers to the business risk of the project, independent of the specific manner in
which the project is financedwhether with debt or with equity. Here is a safe general-
ization: The higher the risk, the higher the required rate of return and the faster man-
agement would want to recover the net initial investment. Why? Because higher risk
means a greater chance that the project may lose money. Management would only be
willing to take this added risk if it was compensated with a higher expected return.
The RRR used in discounted cash flow analysis should be internally consistent
with the approach applied to predict cash inflows and outflows. The options include
various combinations of (1) the real rate and the nominal rate and (2) the pretax and
the after-tax rate. The differences among these rates can be sizable, given estimates
of inflation that may exceed 10% and corporate tax rates of 30% or more.
Organizations typically use at least one of the following approaches in dealing
with the risk factor of projects (see Global Surveys of Company Practice on p. 863):
1. Varying the required payback time. Companies such as Nissan that use pay-
back as a project selection criterion vary the required payback to reflect differ-
ences in project risk. The higher the risk, the shorter the required payback
time. When faced with higher risk, companies also evaluate how to minimize
their downside risk if the project is prematurely abandoned before the full cash
inflows can be realized. A reason for abandoning a project prematurely arises
(as it did for Ontario Power Generation) when government policies regarding
environmental protection change and current projects in operation, such as a
coal-fired electricity-generating plant, cannot be refurbished (see the Concepts
in Action feature on p. 867).
4
2. Adjusting the required rate of return. Companies such as DuPont and Shell
Oil use a higher required rate of return when the risk is higher. Estimating a
precise risk factor for each project is difficult. Some organizations simplify the
task by having three or four general-risk categories (for example, very high,
high, average, and low). Each project under consideration is assigned to a spe-
cific category. Management uses a predetermined discount rate, assigned to
each category, as the required rate of return for projects in that category.
3. Adjusting the estimated future cash inflows. Some companies, such as Dow
Chemical, reduce the estimated future cash inflows of riskier projects. For
example, they may systematically reduce the predicted cash inflows of very-
high-risk projects by 30%, high-risk projects by 20%, and average-risk projects
by 10%, and make no change to the projected cash inflows of low-risk projects.
This approach is called the certainty equivalent approach. Since the cash flows for
higher-risk projects have already been adjusted downward for their increased
riskiness, the RRR used to evaluate those projects is the same as the RRR for
low-risk projects. Note how this approach contrasts with adjusting the required
rate of return. In that approach, the cash flows are not adjusted for risk, but the
RRR is. In the certainty equivalent approach, the cash flows are adjusted for
risk, but the RRR is not. Both adjusting the cash flows for risk and then using
risk-adjusted RRRs would double-count the risk adjustment.
O B J E C T I V E 7
Describe alternative
approaches used to
recognize the degree of risk
in capital budgeting projects
4
See J. Grinyer and N. Daing, The Use of Abandonment Values in Capital BudgetingA
Research Note, Management Accounting Research 4 (1993).
Ontario Power Generation
Operations
www.opg.com/ops/H_hydro_
overview.asp
4. Sensitivity (what-if) analysis. Companies such as Consumers Energy Company
use this approach to examine the consequences of changing key assumptions
underlying a capital budgeting project (see the Concepts in Action box on p. 865).
5. Estimating the probability distribution of future cash inflows and outflows for
each project. Companies such as Niagara Mohawk use the approach to uncertainty
that was discussed in the appendix to Chapter 3. The approach gives due weight to all
possible cash flow outcomes to arrive at an expected cash flow and then discounts this
amount at the risk-adjusted required rate of return for the investment. Estimating
these probability distributions is difficult, but a practical guideline is to limit the num-
ber of outcomes under consideration to a small, manageable set. Consider another
benefit of estimating the probability distribution of future cash inflows and outflows.
Suppose a project has a 60% likelihood of very high cash inflows and a 40% likeli-
hood of minimal cash inflows in its early years. This 40% probability may prompt
managers to establish lines of credit with a bank. If the low outcome occurs, these
lines of credit would enable the company to avoid a short-run cash flow crisis.
863
CAPITAL BUDGETING:
A CLOSER LOOK
Applicability To Not-for-profit Organizations
Discounted cash flow analysis applies to both profit-seeking and not-for-profit
organizations. Almost all organizations must decide which investments in long-term
assets will accomplish various tasks at the least cost.
CMS Energy
www.cmsenergy.com/AboutCMS
Risk Adjustment Methods in Capital Budgeting
How do companies around the globe adjust for risk when evaluating capital investments?
The percentages in the following table indicate how frequently particular risk adjustment
methods are used in capital budgeting in four countries. The reported percentages
exceed 100% because some companies use more than one risk adjustment method.
Dashes indicate information was not disclosed in survey.
United United
Canada* States

Australia

Kingdom

Taiwan
||
Poland
#
Sensitivity analysis 59% 29% 57% 63% 10%
Increase the required rate of return 31% 18% 42% 61% 13%
Shorten payback period 24% 17% 34% 72% 25%
Estimate probability distribution
of future cash flows 18% 12% 11% 15% 13%
Compare optimistic and
pessimistic forecasts 63%
Make subjective,
nonquantitative assessment 29% 54% 37% 22% 69% 4%
Make no adjustments 10% 37%
The surveys indicate that the specific methods managers use vary among countries.
A common feature, however, is that managers appear to favour simpler methods (for
example, sensitivity analysis, shortening the payback period, increasing the required rate
of return, and subjective, nonquantitative assessments) rather than more sophisticated
techniques (for example, estimating the probability distribution of future cash flows).
Adapted from:
*
Jog, V., and A. Srivastava, Corporate Financial Decision Making in Canada, Canadian Journal
of Administrative Sciences (1994);

Sullivan, C., and K. Smith, Capital Investment Justification for U.S. Factory
Automation Projects, Journal of the Midwest Finance Association;

Freeman, M., and G. Hobbes, Capital

Budgeting: Theory versus Practice, Australian Accountant ;

Ho, S., and R. Pike, Risk Analysis in Capital

Budgeting Contexts: Simple or Sophisticated? Accounting and Business Research;
||
Ho, S., and L. Yang,
Managerial Risk Taking and Handling in Corporate Investment: An Exploratory Study in Taiwan, Proceedings
of the Second International Conference on Asian-Pacific Financial Markets;
#
Zarzecki, D., and T. Wisniewski,
Investment Appraisal Practice in Poland (Working Paper, Szcecin University, Szcecin, Poland).
G L O B A L S U R V E Y S O F C O M P A N Y P R A C T I C E
Studies of the capital budgeting practices of government agencies at various
levels (federal, provincial, and local) and in several countries report that, as in the
profit-oriented sector, the following prevails:
1. Urgency is an important factor when allocating funds. For example, capital
budgeting for roads is often motivated by physical deficiencies in an existing
highway rather than a systematic analysis of alternative road construction
projects.
2. Project estimates are sometimes systematically biased. For example, studies report
overestimates of the benefits, underestimates of the costs, and underestimates of
the time it takes to construct dams and other irrigation infrastructures.
3. There is a tendency to cut capital-budget projects first when there is a strong
push to balance a budget or reduce a deficit. Consider the effect of efforts to
contain health-care costs in Canada. As a result of these changes and the
increased emphasis on controlling hospital charges through competition and
regulation, hospitals are increasingly using analytical capital budgeting meth-
ods (such as discounted cash flow methods) and are also more carefully audit-
ing the benefits of capital expenditures.
864 CHAPTER 22
Implementing The Net Present Value Decision Rule
Executives in both profit-seeking and not-for-profit organizations must frequently
work within an overall capital budget limit. This section discusses problems in using
the net present value method when there is a restriction on the total funds available
for capital spending.
The excess present value index (sometimes called the profitability index) is the
total present value of future net cash inflows of a project divided by the total present
value of the net initial investment. The following table illustrates this index for two
software graphics packagesSuperdraw and Masterdrawthat Business Systems is
evaluating:
Present Value Net Excess
at 10% Initial Present Value Net
RRR Investment Index Present Value
Project (1) (2) (3) (1) (2) (4) (1) (2)
Superdraw $1,400,000 $1,000,000 140% $400,000
Masterdraw 3,900,000 3,000,000 130% 900,000
The excess present value index or profitability index measures the cash flow return
per dollar invested. The index is viewed as particularly helpful in choosing between
projects when investment funds are limited. Why? Because profitability indexes can
identify the projects that will generate the most money from the limited capital
available.
Suppose that the developers of each package require that Business Systems
market only one software graphics package, so accepting one software package auto-
matically means rejecting the otherthat is, the packages are mutually exclusive.
Which package should Business Systems choose?
Using the profitability index, Superdraw will be preferred over Masterdraw,
because it has a profitability index of 140%, which is higher than the 130% for
Masterdraw. But the profitability index analysis assumes that all other things, such as
risk and alternative use of funds, are equal. For example, it assumes that choosing
between Superdraw and Masterdraw has no effect on the other projects that
Business Systems plans to implement. If all other things are not equal, which is
often the case, the profitability index may not result in the optimal choice of invest-
ment projects.
Continuing the Business Systems example, assume that Business Systems has a
total capital budget limit of $5,000,000 for the coming year. It is considering invest-
ing in Superdraw or Masterdraw and in any one or more of eight other projects
O B J E C T I V E 8
Explain the excess present
value index and its usefulness
in capital budgeting
Excess present value index.
Capital budgeting measure in which
the total present value of future net
cash inflows of a project is divided by
the total present value of the net
initial investment.
Consumers Energy Company (CEC) owns pipelines to distribute natural gas to its
customers. About 1,609 of the 32,186 kilometres of Consumers Energys main pipelines are
made of cast iron. Most of CECs pipelines are made of cathodically protected coated and
wrapped steel or of plastic. Gas leaks from cast-iron pipes are almost ten times more
than from the other materials. An important capital budgeting decision for CEC
is how much of the cast-iron pipes it should replace and when. The benefits of
replacing the pipes are lower repairs and maintenance costs and fewer claims
following gas leaks, but the precise benefits are far from certain.
To incorporate uncertainty, Consumers Energy estimates a range of
values for key parametersthe number of times the pipeline might leak, the
quantity of gas that may leak, the dollar claims that may have to be paid, and
the repairs and maintenance costs that may be incurredunder each replace-
ment alternative. CEC uses sensitivity analysis to identify the parameters and
parameter values that most affect the decision and those that do not. It then
develops probability distributions for the key parameters on the basis of
structured interviews with experts in different subject areas. CEC calculates
net present values for the different alternatives by discounting the expected
returns by a risk-adjusted required rate of return. CEC computes net present
values on an after-tax basis, using nominal cash flows and nominal discount
rates to consistently consider the effects of inflation.
CECs analysis indicated that the optimal program was to replace the worst
cast-iron pipes first and all cast-iron pipes over a 40-year period. In the absence of this
detailed and thorough risk-based analysis, CECs managers would have favoured
replacing the cast-iron pipes sooner.
Source: Adapted from Elenbars, K. L., and D. ONeill, Formal Decision Analysis Process Guides Maintenance
Budgeting, Pipeline Industry, October 1994.
C O N C E P T S I N A C T I O N
Risk Analysis in Capital Budgeting Decisions
at Consumers Energy Company
865
CAPITAL BUDGETING:
A CLOSER LOOK
Alternative 1 Alternative 2
Net Excess Total Net Excess Total
Initial Present Present Initial Present Present
Project Investment Value Index Value at 10% Project Investment Value Index Value at 10%
C $ 600,000 167% $1,002,000 C $ 600,000 167% $1,002,000
Superdraw 1,000,000 140% 1,400,000
D 400,000 132% 528,000 D 400,000 132% 528,000
Masterdraw 3,000,000 130% 3,900,000
F 1,000,000 115% 1,150,000 F 1,000,000 115% 1,150,000
$5,000,000* $6,580,000

E 800,000 114% 912,000 E $ 800,000 114% Reject

B 1,200,000 112% 1,344,000 B 1,200,000 112% Reject
$5,000,000* $6,336,000

H $ 550,000 105% Reject H 550,000 105% Reject

G 450,000 101% Reject G 450,000 101% Reject
I 1,000,000 90% Reject I 1,000,000 90% Reject
*Total budget constraint.

Net present value $6,336,000 $5,000,000 $1,336,000.

Net present value $6,580,000 5,000,000 $1,580,000.

EXHIBIT 22-9
Allocation of $5,000,000 Capital Budget: Comparison of Two Alternatives for Business Systems
The NPV method always indicates the project (or set of projects) that maximizes the
NPV of future cash flows. However, surveys of practice report widespread use of the
internal rate-of-return (IRR) method. Why? Probably because managers find this
method easier to understand and because, in most instances, their decisions would be
unaffected by using one method or the other. In some cases, however, the two methods
will not indicate the same decision.
Where mutually exclusive projects have unequal lives or unequal investments,
the IRR method can rank projects differently from the NPV method. Consider
Exhibit 22-10.
5
The ranking by the IRR method favours project X, while the ranking
by the NPV method favours project Z. The projects ranked in Exhibit 22-10 differ
in both life (5, 10, and 15 years) and net initial investment ($286,400, $419,200, and
$509,200).
866 CHAPTER 22
Implementing The Internal Rate-Of-Return Decision Rule
O B J E C T I V E 9
Explain why the internal
rate-of-return and the net
present value decision rules
may rank projects differently
5
Exhibit 22-10 concentrates on differences in project lives. Similar conflicting results can occur
when the terminal dates are the same but the sizes of the net initial investments differ.
IRR Method NPV Method
Annual PV of Annual
Net Cash Flow from Cash Flow from
Initial Operations, Operations,
Project Life Investment Net of Income Taxes IRR Ranking Net of Income Taxes NPV Ranking
X 5 $286,400 $100,000 22% 1 $379,100 $ 92,700 3
Y 10 419,200 100,000 20 2 614,500 195,300 2
Z 15 509,200 100,000 18 3 760,600 251,400 1
EXHIBIT 22-10
Ranking of Projects Using Internal Rate of Return and Net Present Value
(coded B, C, . . . , H, I). Exhibit 22-9 on page 865 presents two alternative combina-
tions of these projects. Note that the project portfolio in alternative 2 is superior to
that in alternative 1, despite the greater cash flow return per dollar invested in
Superdraw than in Masterdraw. Why? Because the $2,000,000 incremental invest-
ment in Masterdraw increases net present value (NPV) by $500,000. The $2,000,000
would otherwise be invested in projects E and B, which have a lower combined NPV
of $256,000:
Net Initial Increase in Net
Present Value Investment Present Value
Masterdraw $3,900,000 $3,000,000
Superdraw 1,400,000 1,000,000
Increment $2,500,000 $2,000,000 $500,000
Project E $ 912,000 $ 800,000
Project B 1,344,000 1,200,000
Total $2,256,000 $2,000,000 $256,000
Note that other than Superdraw, alternative 2 includes projects with the highest
excess present value indexes and excludes those with the lowest excess present value
indexes. The excess present value index is a useful guide for identifying and choosing
projects that will offer the best return on limited capital and that will thereby maxi-
mize net present value. But managers cannot base decisions involving mutually
exclusive investments of different sizes solely on the excess present value index. The
net present value method is the best general guide.
Managers using the IRR method implicitly assume that the reinvestment rate is
equal to the indicated rate of return for the shortest-lived project. Managers using the
NPV method implicitly assume that the funds obtainable from competing projects can
be reinvested at the companys required rate of return. The NPV method is generally
regarded as conceptually superior. Students should refer to corporate finance texts for
more details on these issues, and on the problems of ranking projects with unequal
lives or unequal investments.
In response to concerns about the environment, governments have passed many
laws to restrict companies impacts on the environment. Many companies have viewed
these laws as imposing costs on them, but attitudes are changing. Companies are
increasingly shifting their focus away from pollution control (dealing with the control of
environmentally harmful substances) to pollution prevention (minimizing the creation of
pollution in the first place, through increased efficiency in the use of materials, energy,
water, and other resources). Intelligent use of capital budgeting methods is a key part
of this effort.
Suppose a company invests in new manufacturing equipment that
allows it to use a less costly and nontoxic direct material. Annual cost
savings directly associated with the use of the new equipment include
savings in direct material costs and toxic waste disposal. If the capital
budgeting analysis ended at this point, however, the investment might
show a negative NPV, and the company would, on purely financial
grounds, reject the project.
But companies such as DuPont consider other financial benefits.
These benefits include cost savings in pollution control activities such as
monitoring and testing, permit requirements, and legal compliance report-
ing. These costs are hidden in that they are included in general overhead
accounts but typically not identified with specific manufacturing processes.
There can also be hidden impacts on a companys revenues. For example,
the periodic training of employees in pollution control activities adds to
costs, and, when there is no idle time, results in lost revenues as a result of
having to shut down the plant for a few hours each time a training session
is conducted.
Another form of cost savings is the reduction or elimination of various
fines or penalties that a company might experience because of noncompli-
ance or accidents. Estimating these costs is more difficult and is generally
based on statistical analysis of historical data for the particular company or
industry, probability calculations, and professional judgment. Many companies believe an
uncertain monetary estimate is probably better than ignoring the potential environmental
liability altogether.
Finally, there are more-intangible financial benefits, such as higher revenues
frombeing a more environmentally responsible company. Home Depot buys its lumber
products only from a list of preferred vendors that it knows to conduct environmentally
responsible practices.
Source: D. Jacque Grinnell and Herbert G. Hunt, Capital Budgeting for Pollution Prevention, Journal
of Cost Management ; Environmental Protection Agency, Valuing Potential Environmental Liabilities
for Managerial Decision Making; conversations with consulting firm SmithObrien and company
managements.
C O N C E P T S I N A C T I O N
Capital Budgeting for Pollution Prevention
867
CAPITAL BUDGETING:
A CLOSER LOOK
Companies may claim up to the percentages shown of the UCC in any year for the
specified class of tangible assets (see the table below). The legislation regarding CCA
only allows this annual deduction if the asset can be classified under the act; otherwise
no deduction is permitted. In establishing the initial value of the asset, if the company
has or is entitled to receive financial assistance to acquire the asset, then the dollar value
of this assistance may reduce the assets initial value. In addition, if during the useful life
of the asset its value is reappraised downwards, then the UCC must also decrease.
Class Maximum CCA Tangible Assets in Pool
1 4% Buildings or other structures, including component parts
acquired after 1987
3 5% Buildings or other structures, including component parts
acquired before 1988
8 20% Miscellaneous tangible capital property and machinery or
equipment not included in another class
9 25% Electrical generating equipment, radar and radio equipment
acquired before 1976
10 30% Automotive equipment and general-purpose electronic data
processing equipment with its systems software
12 100% Tools or utensils costing less than $200, videotape, certified
feature films, computer software
29 Property used in manufacturing or processing acquired before
1988 (2 years straight-line)
39 Property used in manufacturing or processing acquired after 1987
(198840%; 198935%; 199030%; after 199025%)
Canada Revenue Agency
www.cra-arc.gc.ca/E/pub/
tp/it285r2/it285r2-e.html
CCA Classes
www.cra-arc.gc.ca/tax/
business/topics/solepartner/
reporting/capital/classes-e.html
Appendix: CCA Classes And Rates
PROBLEM FOR SELF-STUDY
This is a comprehensive review problem. It illustrates both income tax factors and capital
budgeting with inflation.
PROBLEM
Stone Aggregates (SA) operates 92 plants producing a crushed stone that is used
in many construction projects. Transportation is a major cost item. A scale clerk
weighs the products and, on a delivery ticket, records details of the product
shipped: its weight, its freight charges, and whether or not it is taxed.
SA is considering a proposal to use computerized delivery ticketwriting
equipment at each of its 92 plants. One plant has used the equipment as a pilot
site for the past 12 months, generating cash operating cost savings (before taxes)
of $300,000 by improving productivity and by reducing plant operating costs and
excess shipments to customers. The cost analyst estimates that if the equipment
had been in use at all of the companys plants for the past year, net cost savings
would have been $25 million (expressed in todays dollars).
The cost of the equipment for all 92 plants is $45 million, which would
be payable immediately. This equipment has an expected useful life of four
years and a terminal disposal price of $10 million (expressed in todays dollars).
The equipment qualifies for a capital cost allowance rate of 25% declining
balance. Stone Aggregates expects a 30% income tax rate in each of the next
four years.
REQUIRED
1. Does the proposal for the computerized delivery ticket-writing equipment
meet SAs 16% after-tax required rate-of-return criterion? This rate of return
includes an 8% inflation component. (The real rate of return is 7.4%; recall
that nominal rate of return [(1 0.074)(1 0.08)] 1 0.16.) This 8%
inflation prediction applies to both the cost savings and the terminal disposal
price of the equipment. Compute the NPV using nominal dollars and a nomi-
nal required rate of return.
2. What other factors would you recommend that SA consider when evaluating
the computerized delivery ticket-writing equipment?
SOLUTION
1. Exhibit 22-11 shows the NPV computations. To illustrate an alternative
presentation found in practice, the format of Exhibit 22-11 differs from that
of Exhibits 22-4, 22-5, and 22-6 (pp. 855, 856, and 857). The proposal for
computerized delivery ticketwriting equipment has an NPV of $29,560
million, indicating thaton the basis of financial factorsit is an attractive
investment.
2. The analysis in Exhibit 22-11 assumes that net cash savings are $25 million
each year. However, operating and implementation costs in the year of
changeover to new computerized equipment are often 200% higher than in
subsequent years. Consequently, net cash savings may be lower in the first year.
EXHIBIT 22-11
Net Present Value Analysis of Computerized Delivery Ticket-Writing System for Stone Aggregates (in Thousands;
n.d. Nominal Dollars)
A B C D E F
1 Total End of End of End of End of
2 Present Value Year 1 Year 2 Year 3 Year 4
3 Recurring After-Tax Cash Operating Flows
4 1. Recurring cash operating savings (real dollars) $ $25,000 $25,000 $25,000 $25,000
5 2. Cumulative inflation factor (from Table 1, Appendix A for 8%) 1.080 1.166 1.260 1.360
6 3. Cash operating savings (n.d.): 1 2 $27,000 $29,150 $31,500 $34,000
7 4. Tax payments: 30% 3 8,100 8,745 9,450 10,200
8 5. Recurring after-tax cash operating savings (n.d.): 3 4 $18,900 $20,405 $22,050 $23,800
9 6. Present value discount factor (16% nominal) 0.862 0.743 0.641 0.552
10 7. P.V. of recurring after-tax cash operating savings (n.d.): 5 6 $ 58,726 $16,292 $15,161 $14,134 $13,138
11
12 Initial Equipment Investment
13 New equipment $(45,000)
14 Tax shield 7,664*
15 After tax cash flow effect of equipment investment (37,336)
16 Terminal disposal 10,000
17 Lost tax shield (1,829)

18 After tax cash flow effect of terminal disposal (8,171)

19 Net present value $ 29,560
20
21 *Tax shield ($45,000 0.30) $7,664
(2 0.16)
2(1 0.16)
0.25
0.25 0.16
22

Lost tax shield ($10,000 0.30) $1,829

0.25
0.25 0.16
23 (Half-year rule does not apply to disposals.)
The following decision guidelines use a question-and-answer format to summarize the chapters main
points. Each decision presents a key question. The guideline is the answer to that question.
D E C I S I O N P O I N T S S U M M A R Y

T E R M S T O L E A R N

DECISIONS
1. How are operating cash flows
affected by income taxes?
2. What is capital cost allowance
(CCA)?
3. Is an accounting gain on the sale
of a capital asset relevant to an
assessment of the relevant cash
flows related to a new capital
project?
4. What is the essential difference
between the total-project
approach and the differential
approach to capital budgeting
decisions?
5. What is included in the nominal
rate of return that is not in the real
rate of return?
6. To recognize the impact of inflation,
what must be done when using the
nominal approach?
7. Why is it important to recognize
risk when evaluating capital
budgeting projects?
8. What is the excess present value
index?
9. Under what condition can the
internal rate-of-return (IRR) and
the net present value (NPV)
methods rank projects differently?
GUIDELINES
Operating cash flows are multiplied by a rate of 1 minus the tax rate to obtain the after-tax
operating cash flows.
CCA is the ITA equivalent of amortization. It is the only legally allowable deduction permitted
when a corporation calculates the net taxable income on which income taxes will be based.
No. Accounting gains and losses on the sale of capital assets have no cash flow implications.
They are relevant in computing accounting income but are not relevant to an assessment of
the cash flows.
The essential difference is that the total-project approach compares the sum of all of the
cash flows between two projects while the differential approach examines the differences
in cash flows for each type of cash flow that varies between two projects.
The nominal rate of return includes the anticipated rate of inflation due to changes in the
general purchasing power of the cash flows.
In using the nominal approach, the nominal rate of return must be used and applied to cash
flows that have been inflated by recognizing the anticipated rates of inflation.
Risk is an important consideration because riskier projects should require a higher rate of
return to compensate for the additional risk.
The excess present value index is the total present value of future net cash inflows of
a project divided by the present value of the net initial investment.
Different rankings of projects can arise when mutually exclusive projects have unequal
lives or unequal investments.
This chapter contains definitions of the following important terms:
capital cost allowance (CCA) (p. 849)
cumulative eligible capital (CEC) (p. 851)
cumulative eligible capital
amount (CECA) (p. 851)
differential approach (p. 853)
eligible capital property (p. 851)
excess present value index (p. 864)
half-year rule (p. 849)
inflation (p. 858)
marginal income tax rate (p. 848)
net addition (p. 854)
nominal rate of return (p. 859)
real rate of return (p. 859)
tax shield formula (p. 849)
total-project approach (p. 854)
unamortized capital cost (UCC) (p. 849)
A S S I G N M E N T M A T E R I A L

QUESTIONS
22-1 Describe three types of cash flows affected by income taxes.
22-2 It doesnt matter what accounting amortization method is used. The total dollar tax bills are
the same. Do you agree? Explain.