Lecture objectives

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LECTURE 9
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Lecture objectives

• Revision on NPV and IRR
• Conflict between the NPV and IRR rule
• Defining cashflows
• Treating cashflows for tax
• Treatment of depreciation
• Investment evaluation using NPV rule

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NPV and IRR

• NPV is inversely related to the discount rate
  k.
• the IRR is that special discount rate at which
  the NPV
• of the project is equal to zero.

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The NPV and IRR rule

• Conflict between IRR and NPV rules - Looking at
  two projects
• PROJECT 0 1 2
• A -20,000 2,000 36,400
• B -20,000 20,000 15,000
• IRR NPV NPV NPV NPV
• _at_10 _at_15 _at_20 _at_25
• A 40 11,901 9,262 6,944 4,896
• B 50 10,579 8,733 7,083 5,600

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The NPV and IRR rule

• Diagrammatically
• NPV
• A
• B
• 40 50 Discount Rate
• If the projects are Independent - ie the decision
  to take on
• project A in no way impacts on the decision to
  take on project B.
• If the projects are Mutually Exclusive, ie a
  choice has to be made, use NPV method.

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Project Evaluation

• Cashflows
• In evaluating projects we use the finance concept
  of cash flow.
• The rule is to include all cash coming into and
  going out of the project.
• Sunk Costs
• Money that was spent in the past is not included
  when evaluating a project today. For example, if
  a machine was bought 5 years ago, then the cost
  of the machine is not relevant if we are making a
  decision on replacing the machine today.

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Project evaluation

• Opportunity Costs
• When evaluating investments using the incremental
  cash flow method, the value of forgone
  alternative needs
• to be included. For example, if your project
  requires
• land that can be sold today for 100,000, this
  amount is included
• as a cost to the project.
• Cost of an assets
• If an asset needs to be purchase for the project,
  the cost
• of the asset is included as a cash outflow. The
  purchase
• cost is not tax deductible.

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Project evaluation

• Depreciation expense
• This is an allowable expense, but is not a
  cashflow. However the tax deduction on
  Depreciation is.
• The tax saved from the Depreciation expense of an
  asset is a positive (inflow).
• The amount of tax saved
• Depreciated Amount x the tax rate "t"
• Dep x t. (ve)
• Depreciation Straight Line or Reducing Balance.

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Project evaluation

• Example
• Asset is bought for 20,000, if "t" is equal to
  30, life of asset
• is 3 years and the asset is being depreciated at
  5000 per
• annum
• 0 1 2 3
• (20,000)
• Depreciation
• Tax shelter

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Project evaluation

• Sale of an asset
• When projecting the estimated sale value of an
  asset - its
• future sale price is called its scrap value or
  salvage value.
• The money from sales is a cash flow therefore
  must be included.
• The tax effect depends on whether or not a profit
  or loss is
• made on sale.
• If in the above example the asset was sold in
  year 3 for
• 10,000

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Project evaluation

• 0 1 2 3
• (20,000)
• Dep t/s
• 5000x.30 1500 1500 1500
• Sale of
• Asset
• T/shelter on
• Book gain
• Calculating shelter or tax on sale of asset
• Salvage Value
• Book Value
• Book Gain

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Project evalution

• General treatment of cashflows with tax
• All incomes and expenses that are cashflows...
• Income (1-t) net inflow
• Expenses (1-t) net outflow
• All non-cash flow expenses - ie depreciation.
• Expense t net cash inflow.

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Example 1

• A company is looking at a project with a life of
  5 years. The cost of the assets required to run
  the project 2.5m. The after tax required rate
  of return (discount rate) 10, tax 30,
  depreciation 20 straight line. The expected
  salvage value of the assets at year 5 100,000.
  Given the following expected cashflows,should
  this project be undertaken.
• (000's)
• 0 1 2 3 4 5
• SALES 0 1500 1500 1800 300
• EXPNS 300 300 300 300 300

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Examplecont

• General approach
• (,000's) 0 1 2 3 4 5
• Purchase -2500
• S(1-t) 0 1050 1050 1260 210
• E(1-t) -210 -210 -210 -210 -210
• Depn x t 150 150 150 150 150
• Scrap 100
• Tax on sale -30
• Net C/F -2500 -60 990 990 1200 220
• When you discount back these Net cashflows at 10
  NPV -36,343

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Project evaluation

• Another application
• Replacement policy
• There are two ways to tackle this problem
• 1) Determine the NPV of the current machine and
  compare that to
• the NPV of the new machine (where the change is
  immediate)
• 2) Using an incremental approach - determine the
  change of wealth/value should the company upgrade
  plant and equipment.
• ie - we are not looking at total cash flows
  generated - just the change in those cashflows.
  If the net change in the cash flows is positive
  the upgrade should take place - increase the
  firm's value.

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Example 2

• Example
• A company is looking to upgrade a machine used in
  its production process.
• Old Machine New Machine
• Estimated Life 4 years 4 years
• Current Book Value 4,000
• Current Selling Price 5,000
• Est Sale Price _at_ t4 0 3,000
• Current Purchase Price 20,000
• Annual depreciation 1,000 4,000

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Examplecont.

• Currently the level of revenue generated is
  30,000 p.a. However since the new machine
  improves the quality
• of the product, sales is expected to increase by
  1,200 p.a.
• The old machine's production costs average
  15,000 p.a.
• but the new machine is expected to save 700 p.a.
  The current and expected tax rate over the
  next four years is
• 30 with the return required by the firm set at
  12 p.a.
• Should the firm buy the new machine?

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The NPV and IRR rule

• Method 1
• Old Machine
• Period 0 1 2 3 4
• Sales 21,000 21,000 21,000 21,000
• Costs (10,500) (10,500) (10,500) (10,500)
• T.S. Depn 300 300 300 300
• Net CashFlow 10,800 10,800 10,800
  10,800
• NPV _at_12 32,803

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The NPV and IRR rule

• New Machine
• Period 0 1 2 3
  4
• Sell Old Mach 5,000
• Tax on Profit (300)
• New Mach (20,000)
• Sales 21,840 21,840 21,840 21,840
• Costs (10,010) (10,010) (10,010) (10,010)
  
• T.S. Depn
  1200 1200 1200 1200
• Sale Value 3,000
• T.S. on Sale 300
• Net Cashflow (15,300) 13,030
  13,030 13,030 16,330
• NPV _at_ 12 26,373

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The NPV and IRR rule

• Old machine better by 32,803 - 26,373 6,430
• Sale of the New Machine _at_t4.....
• Tax Benefit _at_ 30 300

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Example .cont.

• Method 2 (incremental) New rather than Old
• Period 0 1 2 3 4
• Sale - Old 5000
• Tax - sale -300
• Prchs-New -20000
• Cash flows
• sales(1-t) 840 840 840 840
• Exp(1-t) 490 490 490 490
• - old dep deduc -300 -300 -300
  -300
• new dep deduc 1200 1200 1200
  1200
• Sale - new 3000
• tax effect 300
• Net c/f - 15300 2130 2120 2130
  5540

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The NPV and IRR rule

• New Machine rather than Old Machine is better by
• NPV - 6,429
• KEEP THE OLD MACHINE.

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Investment allowance

• Given by some Governments as incentive for
  enticing firms to invest in new machinery etc..
• Usually as the purchase of machinery is
  considered capital in nature, the
• cost is not tax deductable.
• An investment allowance enables the firm to
  include some proportion of
• the purchase cost of the machinery to be claimed
  as an expense and thus is
• a tax deduction...
• ie Pay 20,000 for a machine with a 30
  Investment Allowance. You can
• claim 6,000 of the purchase price as a taxable
  expense if the tax rate is 40,
• a 2,400 (.4 x 6,000) positive cashflow from
  the tax dept will occur at t0.