Cost Savings

The second type of benefit relates to the incremental cost savings from the new computer. As previously stated, these savings are assumed to be $42,000 for the next six years. The aftertax benefits are shown in Table 12-19.

Table 12-19 Analysis of incremental cost savings benefits

 

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As indicated in Table 12-19, we take the cost savings in column 2 and multiply by one minus the tax rate. This indicates the value of the savings on an aftertax basis.

We now combine the incremental tax shield benefits from depreciation (Table 12-18) and the aftertax cost savings (Table 12-19) to arrive at total annual benefits in Table 12-20 (column 4). These benefits are discounted to the present at a 10 percent cost of capital. The present value of the inflows is $150,950 as indicated at the bottom of column 6 in Table 12-20.

Table 12-20 Present value of the total incremental benefits

 

We now are in a position to compare the present value of incremental benefits of $150,950 from Table 12-20 to the net cost of the new computer of $135,400 from Table 12-17. The answer of $15,550 is shown here:

Present value of incremental benefits	$150,950
Net cost of new computer	135,400
Net present value	$ 15,550

Clearly there is a positive net present value, and the purchase of the computer should be recommended on the basis of the financial analysis.

Elective Expensing

We have stressed throughout the chapter the importance of taking deductions as early in the life of the asset as possible. Since a tax deduction produces cash flow, the earlier you can get the cash flow the better. Businesses can actually write off tangible property, such as equipment, furniture, tools, and computers, in the year they are purchased for up to $250,000 under the 2008 Economic Stimulus Act. This is clearly superior to depreciating the asset when the write-off must take place over a number of years. This feature of elective expensing is primarily beneficial to small businesses because the allowance is phased out dollar for dollar when total property purchases exceed $800,000 in a year. Thus a business that purchases $1,050,000 in assets for the year no longer has this option.

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SUMMARY

The capital budgeting decision involves the planning of expenditures for a project with a life of at least one year and usually considerably longer. Although top management is often anxious about the impact of their decisions on short-term reported income, the planning of capital expenditures dictates a longer time horizon.

Because capital budgeting deals with actual dollars rather than reported earnings, cash flow instead of operating income is used in the decision.

Three primary methods are used to analyze capital investment proposals: the payback method, the internal rate of return, and the net present value. The first method is normally unsound, while the last two are acceptable, with net present value deserving our greatest attention. The net present value method uses the cost of capital as the discount rate. In using the cost of capital as the discount, or hurdle, rate, we affirm that a project must at least earn the cost of funding to be acceptable as an investment.

As demonstrated in the chapter, the two forms of benefits attributed to an investment are (a) aftertax operating benefits and (b) the tax shield benefits of depreciation. The present value of these inflows must exceed the investment for a project to be acceptable.

LIST OF TERMS

cash flow 381

payback 384

net present value 385

internal rate of return (IRR) 387

mutually exclusive 389

reinvestment assumption 390

modified internal rate of return (MIRR) 391

capital rationing 392

net present value profile 393

modified accelerated cost recovery system (MACRS) 397

asset depreciation range (ADR) 397

replacement decisions 400

incremental depreciation 403

elective expensing 404

DISCUSSION QUESTIONS

1. What are the important administrative considerations in the capital budgeting process? (LO12-1)

2. Why does capital budgeting rely on analysis of cash flows rather than on net income? (LO12-2)

3. What are the weaknesses of the payback method? (LO12-3)

4. What is normally used as the discount rate in the net present value method? (LO12-5)

5. What does the term mutually exclusive investments mean? (LO12-4)

6. How does the modified internal rate of return include concepts from both the traditional internal rate of return and the net present value methods? (LO12-4)

7. If a corporation has projects that will earn more than the cost of capital, should it ration capital? (LO12-5)

8. What is the net present value profile? What three points should be determined to graph the profile? (LO12-4)

9. How does an asset’s ADR (asset depreciation range) relate to its MACRS category? (LO12-2)

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PRACTICE PROBLEMS AND SOLUTIONS

Cash flow

(LO12-2)

1. Systems Software has earnings before depreciation and taxes of $180,000, depreciation of $60,000, and a tax rate of 35 percent. Compute its cash flow.

Depreciation and net present value

(LO12-4)

2. Archer Chemical Corp. is considering purchasing new equipment that falls under the three-year MACRS category. The cost is $200,000. Earnings before depreciation and taxes for the next four years will be:

Year 1	$ 90,000
Year 2	105,000
Year 3	85,000
Year 4	35,000

The firm is in a 30 percent tax bracket and has a 12 percent cost of capital. Should it purchase the new equipment?

Solutions

1.

Earnings before depreciation and taxes	$180,000
Depreciation	60,000
Earnings before taxes	$120,000
Taxes @ 35 percent	42,000
Earnings after taxes	$    78,000
Depreciation	60,000
Cash flow	$138,000

2. First determine annual depreciation based on the $200,000 purchase price. Use Table 12-12 for the annual depreciation rate for three-year MACRS depreciation.

 

Then determine the annual cash flow for each year.

 

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Finally, determine the present value of the cash flows and compare that to the $200,000 cost to determine the net present value.

 

The net present value is positive, and the new equipment should be purchased.

PROBLEMS

Selected problems are available with Connect. Please see the preface for more information.

Basic Problems

Cash flow

(LO12-2)

1. Assume a corporation has earnings before depreciation and taxes of $90,000, depreciation of $40,000, and a 30 percent tax bracket. Compute its cash flow using the following format:

Earnings before depreciation and taxes	_________
Depreciation	_________
Earnings before taxes	_________
Taxes @ 30%	_________
Earnings after taxes	_________
Depreciation	_________
Cash flow	_________