2011_Week_5_-_The_Time_Value_of_Money_-_Making_Investment_Decisions

2. Identification of Relevant Cash Flows Depreciation (Continued):
The following 4 points should be noted in relation to the depreciation charge:
1.
2.
Sales tax, delivery charges and installation are treated as being part of the cost of equipment. Therefore, they are added to the cost of the asset for the purpose of calculating depreciation; In some jurisdictions it is possible to depreciate an asset down to zero even if it has a salvage value. However, in this course, if the equipment has a salvage value at the end of its useful life, the asset is depreciated down to this value. Consider the following example:
Financial Markets and Systems Lecture 5
The Time Value of Money: Making Investment Decisions
1. Lecture Overview
In this lecture, we will discuss how to use the time value of money concepts introduced in Lecture 2 to identify the projects a firm should undertake. It is important to be able to do this as firms only have limited resources and therefore only want to take on the best available projects. We call this evaluation process capital budgeting.
2. Identification of Relevant Cash Flows
Example: Incremental Cash Flows
Imagine Arnotts Biscuits is considering introducing the white chocolate Tim Tam biscuit. The new biscuit is expected to generate net cash flows of $10 million. However, it is also expected that a number of consumers of current types of Tim Tams will switch to the new type. If $1 million of the $10 million net cash flows described above comes from existing customers, the incremental cash flow from the new biscuit is $9 million. It is the $9 million that is of concern in evaluating whether the new biscuit should be launched.
2. Identification of Relevant Cash Flows
Salvage Value Example:
If an asset costs $20,000, has an estimated salvage value of $5,000 and a useful life of 5 years, the annual straight-line depreciation charge is calculated as:
$20, 000 − $5, 000 D= 5 = $3, 000
2. Identification of Relevant Cash Flows
3.
4.
If an asset is sold for a price greater than its depreciated (or book) value, the excess is a taxable gain. Conversely, if the asset is sold for a price less than the depreciated value, the difference is an allowable deduction for tax purposes. Costs associated with old equipment, including removal expenses, are not regarded as part of the cost of the new machinery and therefore are expensed immediately (ie at time 0).
X t = (1 − τ )( Rt − Et ) + τ Dt − I t
2. Identification of Relevant Cash Flows
Using this terminology, we can define the incremental net cash flows of a project, ∆Xt, as follows:
1. Lecture Overview
In introducing the concept of capital budgeting, we will discuss: • Which cash flows should be taken into consideration when deciding whether to undertake a project; • The use of the net present value rule in project evaluation; and, • How the net present value rule can be used to choose between mutually exclusive projects and projects with different lives.
∆X t = X t ( withproject ) − X t ( withoutproject ) = (1 − τ )(∆Rt − ∆Et ) + τ∆Dt − ∆I t
2. Identification of Relevant Cash Flows Depreciation:
In identifying the firm’s net cash flows for a project in period t, we will use depreciation figures calculated using the straight line method. Under the straight line approach, equal amounts are written off each year, thereby simplifying related calculations. In practice, however, the firm would choose to use an accelerated depreciation method if it were allowed to take advantage of tax shields as early as possible.
2. Identification of Relevant Cash Flows
When considering an investment project, it is important to note we are only concerned with the incremental cash flows associated with the project. The incremental net cash flow of a project is defined as the difference between the firm’s cash flows if the project is undertaken and the firm’s cash flows if the project is not undertaken.
= Rt − Et − I t − Tt
2. Identification of Relevant Cash Flows
How is income tax calculated? Income tax paid, Tt, is calculated as follows:
Tt = τ ( Rt − Et − Dt )
2. Identification of Relevant Cash Flows
Substituting: I − Dt )
Yields the following expression for the firm’s cash flow in period t:
Where: Rt = Cash revenues generated by the firm in period t; Et = Cash revenues paid by the firm in period t (NB: Does NOT include depreciation); It = Capital expenditure paid in period t; and, Tt = Income taxes paid in period t.