NPV, CAPITAL

BUDGETING AND
RISK
ChaptersANALYSIS
8 & 9 : Classes 4

Topics Covered
2

Cash Outfows.
Cash Flow Issues.
Project Expansion and
Abandonment
Depreciation CCA.
Terminal Cash Flows.
Capital Budgeting:

Expansion Projects
Replacement Projects.

Unequal Lives.
Sensitivity and Break Even
Analysis NPV, Capital Budgeting and Risk

Chapters 8 & 9

Cash Outfows
3

Expenditures on fxed assets are cash

outfows.

Includes shipping & installation.

Expenditures on working capital are cash

outfows.

New projects increase current assets

and current liabilities.
Spontaneous uses of cash increase
more than spontaneous sources of
cash must fnance gap.
Investments in working capital have an
NPV, Capital Budgeting and Risk

Chapters 8 & 9

Some Cash Flow Issues

4

Marginal or incremental cash fows - the

stand alone principle.
Sunk costs.
Opportunity cost.
Externalities / intangibles.
If cash fows are real
Infation.

than cost

Financing charges. of capital must be

too!
Tax effects.
CCA
Terminal
cash to abandon
The opportunity
and to
impacts
fows.
expand.
and NWC

NPV, Capital Budgeting and Risk

Chapters 8 & 9

Think Incrementally
5

1.

2.
3.

Only consider incremental costs, i.e.,

costs resulting from project--not costs
incurred prior or costs that would be
incurred regardless.
Incremental approach equivalent to
comparing two valuations of frm: with
the new project and without.
7.
Externalities
/
The
opportunity
If difference is4.positive
then
accept
new
intangibles.
to
5.
project.
abandon & to
Inflation.

Marginal
or

incremental
cash flows.

Sunk costs.
Opportunity cost.

6.

Financing charges.

NPV, Capital Budgeting and Risk

8.
9.

expand.
Tax effects.
Terminal cash
flows

Chapters 8 & 9

Samurai Tailors Inc.

6

Samurai Tailors Inc. has $C cash and expects

after tax cash flows of $CFNS in each of the
next 2 years. The cost of capital is k%
Samurai Sam is considering buying a new
sword for $C, which will increase his tailoring
speed and increase annual cash flows to
$CFWS > $CFNS
He should buy the sword if the value of the
firm
with the
sword
is greater than
the 0
CF
$ C
CF
If C F
1
(1
(1
(1
value (without:
C

F
WS

WS

NS

k)
Incremental Cash
Flows:

k)

NS

k)

k)

C F W S - C FN S
C FW S

$
C

(
1

(1
0
2
C
F
N
S
k ) flows is
k)
incremental
cash

If the NPV of
positive undertake project.
NPV, Capital Budgeting and Risk

Chapters 8 & 9

Ignore Sunk Costs

7

Costs already incurred prior to the

project should not be allocated to the
project.
Sunk costs are ancient history
irrevocable so should not affect
future decisions.
Accepting project makes contribution
towards those4. costs.
1.
7.

Marginal or
incremental
cash flows.

2.
3.

Externalities /
intangibles.
Inflation.

The opportunity
to
5.
abandon & to
expand.
6.
Sunk costs.
Tax effects.
Financing charges. 8.
9.
Opportunity NPV,
cost.Capital Budgeting and Risk
Terminal
cash
Chapters
8&9

Opportunity Costs
8

1.

2.
3.

Cost of chosen act is the most

valuable forsaken alternative
opportunity.
The use of assets that do not have a
direct price, i.e., machines that the frm
already owns, have an opportunity cost
equal to the profit foregone on the best
alternative production opportunity.
Marginal or
incremental
cash flows.

4.
5.

Externalities /
intangibles.
Inflation.

6.
Sunk costs.
Financing charges.
OpportunityNPV, Capital Budgeting and Risk

7.

The opportunity
to
abandon & to
expand.
8.
Tax effects.
9.
Terminal
cash
Chapters
8&9

Externalities
9

Externalities, positive or negative,

are benefts granted to or costs
borne by others, and not the frm,
and therefore is not priced in project.
Other intangibles:

1.
2.

Erosion in sales levels of existing

products (caused by entry of new
product).
4.
7.
Marginal or
Externalities
/
opportunity
Synergies
gained
if introduction
ofThenew
incremental
to
5.
8.
projects
increases
cash fow (reduces
cash
intangib
abandon & to
flows.
les.
expand. Tax
costs)
of
existing
projects.
Sunk
Inflation.
effects.
costs.

NPV, Capital Budgeting and Risk

Chapters 8 & 9

10

Infation and Capital

Budgeting

Infation impacts both the interest rate

and the cash fows:
1+real interest rate =

1 + nominal interest

rate
1 + inflation rate
real cash flow =

nominal cash flow

1
+ inflation rate

The opportunity
Real cash fows must be discounted
to
2.
8.
abandon & to
with the real interest rate, and
expand. Tax
nominal cash fows must be Chapterseffects.
8&9
1.

4.
Marginal or
Externalities /
incremental
5.
cash
intangibles.
flows.
Inflation.
Sunk
NPV, Capital Budgeting and Risk
costs.

7.

11

Nominal versus Real cash

Flows Example

Economists at Microsoft predict that the

sales of the Windows operating system will
continue in perpetuity. They forecast
$100M in after-tax cash fows (in todays
dollars) each year starting one year from
now. Assume year-end cash fows. Infation
is forecast at 4%. The nominal cost of
capital is 10%.

What is the real rate?

What is the PV of after-tax cash flows in real
1 + nominal interest rate
nominal cash flow
1+real interestdollars?
rate =
real cash flow =
What is the
1 + PV
inflation
+ inflation rate
of rate
after-tax cash flows1in

NPV, Capital Budgeting and Risk

Chapters 8 & 9

Financing Charges
12

Exclude the cost of capital.

The cost of equity, debt etc. is

accounted for in the discount rate, k,
that we use.

The capital budgeting decision is

separate from the fnancing decision.
If we use k as the discount rate in our
NPV calculation, we are saying that we
will earn enough returns to compensate
4.
7.
Marginal
or security
Externalities /
The opportunity
all our
holders.

1.

incremental cash
Anything
flows.

2.

intangibles.
Inflation.
left5.over
(a positive

accrue to shareholders
and
6.
Financing

Sunk costs.

NPV, Capital Budgeting and Risk

to
NPV) abandon
will & to
expand.
increase
8.
Tax
Chapters
8 &effects.
9

13

The Opportunity to Abandon

and Expand

If project is truly value increasing,

then frm may want to replicate
project or expand.
If project does not produce value,
then frm may want to close facility.
Or there may be a frst mover
advantage or strategic option that
makes a negative NPV project valuable.
1.
4.
Marginal or
Externalities / 7.
The opportunity
Another
possible
option
is
the
option
incremental
to
2.
5.
8.
cash
intangib
abandon & to
to
delay
the
start
of
a
project.
flows.
les.
expand. Tax
Sunk

Inflation
NPV, Capital Budgeting
and Risk

effects.
Chapters
8&9

14

Decision Trees & Capital

Budgeting Stewart
The Stewart Pharmaceuticals Corporation is
Pharmaceuticals
considering investing in the development a drug

that cures the common cold. The cost of capital for

this project has been estimated to be 10%.
A corporate planning group, including
representatives from production, marketing, and
engineering, has recommended that the frm go
ahead with the test and development phase.
This preliminary phase will last one year and cost
$1 billion. Furthermore, the group believes that
there is a 60% chance that tests will prove
successful.
If the initial tests are successful, Stewart
Pharmaceuticals can go ahead with full-scale
production. This investment phase will cost
$1,600 million. Production will occur over the next
four years.
NPV, Capital Budgeting and Risk

Chapters 8 & 9

15

Stewart Pharmaceuticals NPV of

Full-Scale Production following
Successful
Investment
Year Test
Years 21
Revenues

$7,00
0
Variable
(3,000
Costs
)
Fixed Costs
(1,800
)
Depreciation
(400
)
Pretax proft
$1,80
0
Tax (34%)
(612
)
4
Net Proft
$1,18
$1,
$3,
NPV $1, 600 588
8
(1.1 433.75
Depreciation NPV, Capital
400
Risk
0) t Budgeting and

Note that the NPV

is calculated as of
date 1, the date
at which the
investment of
$1,600 million is
made. Later we
bring this number
back to date 0.

Chapters 8 & 9

Stewart Pharmaceuticals NPV of

Full-Scale Production following
Unsuccessful Test
Investment

Year
1

Years 2Note that the

5
Revenues
$4,05
NPV is
0
calculated as
Variable
(1,735
of date 1, the
Costs
)
date at which
Fixed Costs
(1,800
the
)
Depreciation
(400
investment of
)
$1,600 million
Pretax proft
$115
is made.
Tax (34%)
(39.10
Later we
)
4
this
NPV $75.9
$1, 600 $475.bring
Net Proft

90
(1.1 number
NPV, Capital Budgeting
0 and Risk
$91.46back
Chapters 8 & 9
Anatly1sis

0)t

17

Decision Tree for Stewart

Pharmaceutical

The firm has two

decisions to make:
Succe
To test or not
ss
to test To
invest or not
Te
invest
st
Failur
e
NPV
Do not
$0
NPV, Capital Budgeting and Risk
test
Analysis

Inve
st
NPV $3,
433.75m

Do
not
inve
st

NPV =
$0

These after-test
NPVs in time 1
currency.

Inve
st
NPV

Chapters 8 & 9
$91.461m

18

Stewart Pharmaceutical:
Decision to Test

Lets move back to the frst stage,

where the decision boils down to the
simple question: should we test?
If we dont test, the NPV of doing
nothing is ???
If
test, the
expected
is we
Expected
Prob.
Payoff payoff
Prob.
Payoff

evaluated
at date 1
:
pay
sucess given success
failure
off

Recall the given

cost failure
to test is $1 billion.
So the NPV evaluated at date 0 is
???
NPV, Capital Budgeting and Risk
Analysis

Chapters 8 & 9

19

Option to Abandon by
Example
You have been hired as a financial analyst to

do a feasibility study of a new video game for

Passivision. Marketing research suggests that
Passivision can sell 12,000 units per year at
$62.50 net cash flow per unit for the next 10
years. The relevant discount rate is 12%. The
required initial investment is $10 million.

What is the base case NPV?

After 1 year, the project can be abandoned

and $500,000 can be recouped. After 1 year,
expected cash flows will be revised upward to
$1.5 million or $0 per year for the remaining
lifetime of the project, each occurring with
equal probability. What is the option value of
abandonment? What is the revised NPV?
NPV, Capital Budgeting and Risk

Chapters 8 & 9

20

Taxation Issues - Capital Cost

Allowance (CCA)

Government allowable
depreciation reduces earnings and
thus creates a tax shield.
When we look at cash fows, we dont
care about the depreciation but we care
about the tax effects of depreciation.

1.
2.

4.
Marginal or
Externalities /
incremental
5.
cash
intangib
flows.
les.
Sunk
NPV, Capital BudgetingInflation
and Risk

7.

The opportunity
to
8.
abandon & to
expand.
Chapters 8Tax
& 9 efects.

Operating Cash Flows

21

With and without CCA

Revenues
Less:

Expense
s
CCA
Taxable Income
Taxes (at 50%)

$10
0
$50

$100
-$50
-$20
$30
-$15

$50
$25
Net Income
$25
$15
Add: CCA
+$0
+$20
Operating Cash
$25 and Risk $35
NPV, Capital Budgeting
Analysis

Depreciation
deductibility
increases operating
cash fows by:
TC*CCA = 0.5*20
= 10.

Chapters 8 & 9

CCA Calculations
22

Assign asset to correct CCA class,

which gives the maximum
depreciation rate for that class:

A higher CCA rate: asset depreciates faster,

tax shield is earned sooner.
Land is not a depreciable asset!
Government can use CCA rates to affect a
firms investment decision.

If there are a number of assets in any

given class, then those assets are pooled
and treated as one.
Acquisitions
to a class include Chapters
purchase
NPV, Capital Budgeting and Risk
8&9

CCA Calculations
23

CCA uses a declining balance

depreciation method.

Example:

A
$10M
has a depreciation
year rule: Only depreciate
The
yearinvestment
1 CCA
rate
d = 5%.
of the
capital
cost in the
deduction
CCA1 = d/2is:
* 10 = 0.05/2 * 10 =0.25
frst year.
million
At year-end the undepreciated balance (undepreciated
Text uses C instead of
capital cost or
UCC)
UCC0
is
UCC = UCC CCA = 10 - 0.25 = $9.75

million.

In
the second
the1CCA
deduction
CCA
= year
d x UCC
= 0.05
* 9.75 =is$0.4875
million.
2
= UCC1 - CCA2 = 9.75 -.4875 =
UCC
$9.2625 mil
2

Capital
Budgeting and Risk
=NPV,
UCC
0 - CCA1 - CCA2

Chapters 8 & 9

24

A CCA
Example

Alba Ltd. which has a 36.5% combined tax rate

buys a machine for $100 000 in 2006 which
qualifies it for a 25% CCA. Costs of $15 000
were incurred to install and commission it. It is
the only asset in its class. Calculate the CCA
Year
UCC start
CCA
UCC End
Tax Savings
and the tax savings for the first 5 years.

2006
2007
2008
2009
2010

We can calculate the UCC in any year as UCCn =

n-1
UCC0(1-0.5d)(1-d)
NPV, Capital Budgeting and Risk
Chapters 8 & 9

Terminal Year Cash Flows

25

Salvage ($S) of assets:

1.

2.

Funds from sale of assets are cash infows

at end of last year.
There could be a capital gain if the salvage
exceeds the original purchase price of the
asset.
And because of
Canadian taxation rules,
there will be an adjustment to the CCA
that can be claimed in the future.

Recovery of working capital:

or
Marginal
Production
incremental cash
flows.
continue.

4.

/
ceasesExternalities
but
sales
intangibles.
5.
Inflation.

7.

The opportunity
from inventory
to

abandon & to
expand.
May or may not equal initial NWC investment.
6.
8.
Sunk costs.
Tax
Financing
charges. Chapters
NPV, Capital Budgeting
and Risk
8 & 9effects.

Capital Budgeting
26

Take the present value of all cash fows accruing

to the project.
Discount rate is k, the weighted average cost of
capital.
Components of the project are:
PV of initial investment (equipment expenditure)
include time 0 operating cash fows.
PV of operating cash fows from time 1 onward.
PV of CCA tax shields.

1.
2.
3.

PV of salvage & impact on CCA tax shields.

4.

5.

PV of tax shield.
Lost of tax shields from selling asset at end of project.
Capital gains if salvage exceeds purchase price.
Adjustment if asset is last asset in the pool.

PV of net working capital (both current and

future changes)
NPV, Capital Budgeting and Risk
Chapters 8 & 9

27

Initial Outlay / Equipment

Expenditure

EE - net after tax cash fow that occurs

of equipment,
facilities and land
at time
0.
0 Cost

Not all of these costs are necessarily

depreciable:

purchased.
All other costs related to investment.

Some may be expensed immediately

(that is the cost generates an immediate
tax savings);
Some belong to different asset classes (could
affect several CCA pools);
Some may not generate any tax implications.
NPV, Capital Budgeting and Risk

Chapters 8 & 9

Operating Cash Flows

28

TC - tax rate
k is firms cost of capital.
OCF1, OCF2...OCFn - before tax operating cash
flows for n years of project.

Revenues - Expenses

Need to calculate after tax flows.

Deviate from text and consider CCA tax shields
separately.
n
Present value of cash flows starting at
time
1
PV
+
+...
OCF 1OCF 1-T OCF 1-T
OCF 12
j
1+
j=
is =
n
+

1
1+k
1+k

If all cash kflows are

identical, we can use
T
T
the annuity formula for
the present

1+kn
1 1
value:

OCF

PVOCF =OCF1 1-T k

c

NPV, Capital Budgeting and Risk

Chapters 8 & 9

CCA Effects
29

Notation:

d - the rate of depreciation for declining

balance.
S - salvage value.
C capital cost of asset posted to pool.

If straight line depreciation, present

PVCCA TS =TC * C-S 1- 1+k Note that we are ignoring
value of tax shield
is:
n
k
year rule

the
If declining balance
depreciation,
here.
present value of tax shield is:
-n

PVTS C d TC 1 0.5k
1

k

d
k
NPV, Capital Budgeting and Risk

Term adjusts for

half-year rule.
Chapters 8 & 9

Present Value of Salvage

30

Present value of
salvage is
PVSalvage =

1+k

If the salvage pricen ($S) is above the

the firm pays taxes
purchase price ($C)
on the capital gain:
PVCapital gain = TC 0.5 S-

1+k

NPV, Capital Budgeting and Risk

Chapters 8 & 9

31

Selling an Asset from an

Ongoing Pool

The salvage price $S is deducted from

the balance in the asset pool.
If the salvage price is less than the
undepreciated capital cost ($S < UCCn),
then the asset continues to generate a
tax deduction even after it is gone!
If $S > UCCn, then disposition decreases
tax shields from other parts of the
business forever.
NPV, Capital Budgeting and Risk

Chapters 8 & 9

32

PV of CCA Tax Shields

Declining Balance

Assume that pool is not closed out and

the salvage is less than the purchase
price of the asset.
Then the asset pool is written down by
the amount of the salvage and these
S d TC
1

PVTS lost
tax shields
are lost
after
disposition:
k
(1 n

d
k)
This formula assumes
that
the asset

is sold at the very beginning of year

n+1, so tax shields from n+1 onward
are impacted.
NPV, Capital Budgeting and Risk

Chapters 8 & 9

33

Selling The Last

Asset: Closing
If $S Pool
> UCC (but less than its original purchase
the

price) then the difference is added to taxable

income and is called recaptured depreciation.

If $S < UCCn, then the remaining balance is called a

terminal loss and is deducted from taxable income.

You claimed too much depreciation expense and paid

too little tax the government wants some back!
Tax Increase = ($UCCn - $S) * TC < 0

You didnt claim enough tax breaks during the life of

the asset.
Tax Rebate = ($UCCn - $S) * TC > 0

If $S > original purchase price ($C), difference

between the 2 values is taxed as a capital gain,
and compare $C with UCCn.

Tax Increase = ($UCCn - $C) * TC - 0.5TC(S-C)

NPV, Capital Budgeting and Risk

Chapters 8 & 9

34

The CCA Formula is Also

Affected

Assume that pool is not closed out and

the salvage is greater than the
purchase price of the asset.
Then the formula for CCA tax shield
lost is slightly different from earlier
slides:
In order to avoid double taxation
(already paying capital gains on the
difference
between the purchase price
price, call it
1

k) pool is

P
and
the
C. the salvage value),
k d

reduced by
theBudgeting
of the
original
amount
TSCapital
lost
NPV,
and Risk
Chapters 8 & 9
n

(1

35

Example of Closing the

Pool

A firm, with a 40% tax rate, buys a van

for $30
000. The van is a class 10 asset which
has a CCA rate of 30%. The van is the
only class 10 asset the frm owns. After
2 years, the frm sells the van.
What is the UCC of the van?
Calculate the tax implications, if

the van is sold for $10 000.

the van is sold for $20 000.
the van NPV,
is sold
for $35
000.
Capital Budgeting
and Risk

Chapters 8 & 9

CCA Tax Shield Problem

36

Six years ago, Kandar Inc. purchased a tool

press machine for $220,000. After
restructuring its industrials division, Kandar
Inc. has just sold the machine for
$250,000. The undepreciated capital cost
for this pool of assets at the time of sale is
$210,000. After the sale, Kandar Inc. will
have no other assets in this pool. Assets in
this class have a CCA rate of 15%.
If Kandars tax rate is 34%, fnd the amount
of the companys tax liability or credit
resulting from
this asset sale. Chapters 8 & 9
NPV, Capital Budgeting and Risk

Net Working Capital

37

Notation:

NWC0 - initial change in NWC (usually negative)

NWCn - release of NWC at end of project

Arises due to raw materials purchased before sale of

fnished goods and cash kept as buffer against
unexpected project costs.
No more project costs but inventory of fnished goods
is being sold. NWC

NWC = NWC +
n
PV
Present
value
of
any
changes in NWC
0
n
1+
Final sign will be positive
if there is a net
decrease in NWC and negative if there is a net
increase in NWC.k
Note that there could also be changes in NWC
over the life of the project.

NPV, Capital Budgeting and Risk

Chapters 8 & 9

38

Putting it All Together

Expansion Project

NPV Calculation (if salvage < purchase

price)
NPV = Initial Investment + PV operating
cash fows + PV CCA tax shields from the
initial investment + PV salvage PV CCA
NPVshields
= EE + PV
tax
lost+due
toforever
salvage
+CCA
PV
NWC
PVCCA TS
+PVSalvage - PV
TS lost
impacts.
+ PV
0

OCF

NW C

C
OCFj 1-Tc C d T 1 0.5k
k d 1
j=1
=EE
1+k j

S
1
NWCn
S d TC
0+

+
NW
C
1+k n k (1 n
1+k
NPV, Capital
d Budgeting
k) and Risk
&9
Chapters 8
0

Analysis

39

Putting it All Together

Expansion Project

NPV Calculation (if salvage >

purchase price)

NPV = EE0 + PVOCF + PV

CCA TS forever +PVSalvage
- PVCCA TS lost + PVCapital Gain + PVNWC
n

=EE0

j=1

C
C

T
S

1 0.5k
OCFj 1-T
j c
k d 1
1+k

1+k

k

C
CdT
1 - TC 0.5 nSk
(1 n
1+k
d
k)
C

NPV, Capital Budgeting and Risk

NW Cn

+ NWC0 +

1+k
Chapters 8 & 9

First Example
40

Oddfew Co. has recently raised $10,000,000

through a combined debt and equity issue. Its tax
rate is 40%, and its cost of capital is 12.33%.
One of the projects it is considering is the following:
80% of the $10 million investment will be used to
purchase machinery upon which CCA on a declining
balance can be taken at 30%. The remaining
$2,000,000 is not eligible for CCA deductions, nor
can it be expensed for tax purposes. The
machinery is expected to have a salvage value of
$2.5 million at the end of 6 years.
The project is expected to produce operating
income of
$1,500,000 at the end of the frst year, and this
amount is projected to increase by 10% in the second
year and then remain constant for the remaining 4
years of the project. There are no NWC additions
forecasted. NPV, Capital Budgeting and Risk
Chapters 8 & 9

A Second Example
41

Freeman Construction is considering its allocation of

this years capital budget to project Rebuild. The
frms strategy group has prepared estimates of the
resulting cash fow from the project. The frms cost
of capital of 18% and the frms tax rate is 36%.
Project Rebuild is a long term project. Machinery (CCA
class 43 with a depreciation rate of 30%) for this
project costs $225,000 and has an anticipated life of
11 years. It is anticipated that the machinery will be
worth $20,000 at the end of its life.
There are
additional start-up costs of $30,000 that are not
eligible for CCA deductions, nor can they be are
expensed. Project Rebuild is anticipated to generate
revenues of $77,000 a year over the life of the
project. Project Rebuild requires an initial increase in
working capital of
$20,000. A second increase in working capital to
replenish inventories of $4000 is scheduled at the end
NPV, working
Capital Budgeting
and Risk of $12,000
Chaptersis
8 &expected
9
of year 5, and
capital

Some Complications
42

Suppose frm is deciding among 2

mutually exclusive projects with different
project lives?

e.g. can buy 1 of 2 machines to upgrade

production: Machine A has a useful life of 6
years, and Machine B has a useful life of 9
years.

2 approaches are:

Replacement Chain approach:

Replicate projects over same length of time,

calculate the NPV of each chain and choose one
with highest NPV.

Equivalent
Annual NPV:
NPV, Capital Budgeting and Risk

Chapters 8 & 9

43

Unequal Lives - by
Example
Suppose a frm with a cost of capital of 9%

has access to the following 2 projects.

These projects are mutually exclusive and
future
is expected.
Yearreplacement
Cash Flows Project
Cash Flows
0
1
2
3
4
5

L
-$52,000
$15,000
$15,000
$15,000
$15,000
$15,000

Project S
-$40,000
$18,000
$18,000
$18,000

If we calculate the NPVs of the 2 project is

preferable? Is this a fair comparison?
NPV, Capital Budgeting and Risk

Chapters 8 & 9

Unequal Lives
44

Instead, use the equivalent annual NPV

approach
Replace the lumpy stream of payments
over a projects lifetime with a level
annuity, such that the two payment
streams have the same present value.
For an n year project with a present value
n

1
1
k
NPV

of NPVn, the nequivalent

annual
annuity An
n
k

solves
Compare the equivalent annual NPVs of

both projects and pick

the project with the
highest amount.

NPV, Capital Budgeting and Risk

Chapters 8 & 9

45

When is A Comparison Not

Necessary?

If projects are independent and firm can

undertake both.
If one or both projects have a negative
NPV (would never undertake a negative
NPV project).
If the shorter project has the higher
NPV.

NPV, Capital Budgeting and Risk

Chapters 8 & 9

Unequal Lives Example

46

Norris Bakeries has been making cakes and other pastries in the KW area for the
past 15 years. Demand for their products has grown greatly ever since the KW
Record showcased their products in an About Town article. To keep up with
this growing demand, Norris Bakeries recently spent $70,000 to expand their
facility. They have also hired a new baker at an annual salary of $40,000.

In order to decrease the time it takes to produce their award winning cinnamon
buns, Norris Bakeries is now looking at acquiring a high speed mixer. There are 2
models, both Class 43 assets (CCA rate 30%), that have received rave reviews.

The first mixer, the Sunbeam Pro9000, sells for $80,000. Because of the speed
and quality of the Pro9000, it is expected to generate operating savings of
$23,000 per year over a five year period. At the end of the five years, the Pro9000
is anticipated to have a market value of $17,000. For this mixer, Norris Bakeries
will have to increase its net working capital by $4000 at the beginning of the
project, of which 40% will be recouped at the end of the project.

A second mixer, the KitchenAid Artisan SXZ, has a life expectancy of 8 years. It
retails for $120,000, but because of the longer lifespan, its salvage value is
anticipated to be $9000. The Artisan SXZ has a more powerful motor than the
Pro9000, and hence the operating savings are higher. It is expected to generate
savings of $27,000 a year. The Artisan SXZ requires an increase in inventories of
$4500, of which half can be recouped at the end of the project.
Because of small business
incentives
inand
theRisk
Region of Waterloo,
Norris
NPV, Capital
Budgeting
Chapters 8
& 9 Bakeries

47

A 2nd Unequal Lives

Question
To meet expanding demand, QuickBuild Inc. is looking to purchase a
new packaging machine for its Waterloo plant. (CCA class 8, with a
rate of 20%). Quickbuild has a corporate tax rate of 34% and a cost
of capital of 11%. There are 2 machines that can be purchased.
Regardless of what machine purchased, revenues associated with
this project are expected to be $25,000 a year.
Machine 1

The industry standard machine costs $8500 and is expected to last 6

years. Allowable installation costs on this machine are $500. Experience
has shown that there are 2 drawbacks to this machine. First, that the cost
of operating this machine increases over time. The frm estimates that
operating costs will be $5500 for the frst 5 years after installation, and
$6500 in the last year. And secondly, there is no signifcant salvage
associated with this machine. The frm expects to spend $800 on net
working capital when it purchases the machine. None of this is expected to
be recouped at the end of the project.

Machine 2

There is another machine with an expected useful life of 2 years. The cost
of this machine is
$5100 which includes installation costs. At the end of 2 years, the salvage
NPV,
Chapters 8 & 9
on the machine
is Capital Budgeting and Risk

48

Equivalent Annual Annuity

and Replacement Chain
Method
Equivalent annual annuity this

approach does not allow for the

impact of infation, or changes in
technology.
If there are to be changes in project
cash fows
i.e. changes in future CCA rates, or
equipment expenditures or operating
cash fows in the future, must use
replacement chain method.
In this method,
repeat
one
or
both
NPV, Capital Budgeting and Risk
Chapters 8 & 9

49

Replacement Chain Method By Example

A firm, with a cost of capital of 10%, is

submitting a bid to the government to
produce widgets for 4 years. 2 options are
available to the firm.

Machine A has an after tax installation cost of

$50,000, but is expected to generate after tax
returns of $20,000 a year for 4 years. After 4
years, the machine has no salvage value.
Machine B has only a 2 year lifetime, and its after
tax installation cost is $30,000. For the 2 years, it is
expected to produce after tax returns of $20,000 a
year. When it is replaced after 2 years at a cost of
$30,000, the frm expects to generate after tax
returns ofNPV,
$22,000
a year for 2 years
because of
Capital Budgeting and Risk
Chapters 8 & 9

50

Replacement Projects (not the

same as Replacement Chain
Method)
Think

Incremental!
STEP
1: Incremental Initial Investment:

EE0 = Equipment Expenditure

OLD, at time 0.

Salvage

Leads to change in amount posted to pool C

NWC0.

STEP 2: Incremental Operating Cash Flows:

NEW

Before tax OCF.

STEP 3: Incremental Ending Cash Flows:

Change in Salvage: S = SNEW - SOLD, at time

n (plus any tax effects).
NWCn.
NPV, Capital Budgeting and Risk

Chapters 8 & 9

51

Putting it All Together

Replacement Project

NPV
Calculation
NPV =
+ PVOCF
EE0

forever
-PVCCA
TS lost

+PVCCA TS

+PVSalv

age

C d 1
OCFj j1- T
0

C
j=

=EE
k d 0.5k
1

1+

TS
T 1 k

c d C
NWC

n
0
n
n
S
kk (1 k)
+NWC +

d
1+k

n
PVNWC

If we have capital gains or close out the pool, then

the calculation is even more complicated.The key is
to always1+k
look at incremental values!
NPV, Capital Budgeting and Risk

Chapters 8 & 9

52

A Replacement Project
Example
An officer for a large construction company is feeling

nervous. The anxiety is caused by a new excavator

just released onto the market which makes the one
company purchased a year ago obsolete.
The market value of the old excavator has just gone
from $400,000 from a year ago to $60,000 now. And
in 10 years it will only be worth $10,000.
The new excavator costs $700,000 and would
increase operating revenues by $60,000 a year
over the next 10 years.
Salvage on the new equipment at the end of 10
years is $120,000.
The frms tax rate is 42%, and the frms cost of
capital is 12% and CCA can be taken on both
excavators at 30%.
Should the new excavator be purchased?
NPV, Capital Budgeting and Risk

Chapters 8 & 9

53

Sensitivity and Break Even

Analysis

NPV technique can also be used for

break even analysis.
Discover sensitivity of results to key
inputs.

NPV, Capital Budgeting and Risk

Chapters 8 & 9

A Break-even Example
54

Jennys Jam and Java Jars (JJJJ) is reviewing their

manufacturing process. The company currently purchases
200 000 lids a year for their jars. The outside supplier of
the lids currently charges a price of $2 per lid. The plant
manager believes that it would be cheaper to make the
lids than buy them. She has determined the following
costs:

Direct production costs are expected to be $1.50 per lid.

The necessary machinery would cost $150 000. The new machine
would be a class 10 asset with a CCA rate of 30%. The frm already
has a pool of class 10 assets.
There would be a one time increase of nwc of $30 000, which can be
recovered at the end of the projects lifetime.
The frms corporate tax rate is 46%, and their cost of capital is 15%.
The estimated salvage value of the machine at the end of 10 years
is zero.

Should the frm buy or produce the lids?

What price per
lid would make the frm indifferent
NPV, Capital Budgeting and Risk
Chapters 8 & 9

Another Example
55

We have been requested by a large retailer to

submit a bid for a new point-of-sales credit
checking system. The system would be
installed by us in 20 stores per year for 3 years.
We would need to purchase $200 000 worth of
specialised equipment. This will be depreciated
at a 25% CCA rate. We will sell it in 3 years, at
which time it will be worth 1/2 what we paid for
it. Finally we need to invest $48 000 in working
capital items. There would be no recapture of
working capital at the conclusion of the project.
The relevant tax rate is 44%. What price per
system should we bid if we need a 16% return
on our investment?

Assume that all 60 systems are paid for up front.

Assume that all systems are paid for in the year of
NPV, Capital Budgeting and Risk

Chapters 8 & 9

56

Where Do Positive NPVs Come

From?

Competition in labour/capital markets

should push NPV
0.
Therefore if a project has a positive NPV:

There are unique attributes of the firm/project,

such as

Firm is frst to introduce a new product, use

advertising to create product differentiation, or
can modify existing product to take advantage of
unsatisfed demand.
Firm can redefne core business to deliver
services at a lower cost.
Firm can create barriers to entry.
NPV, Capital Budgeting and Risk

Chapters 8 & 9