When analyzing a real-world project, it is important to ...



When analyzing a real-world project, we must consider the incremental cash flows and opportunity costs caused by the project. A major component of our analysis is the cash flows related to asset purchases and sales and the resulting tax effects.

A. Depreciation

The main tax effects resulting from an asset purchase or sale are due to depreciation deductions.[1] Each depreciation deduction that is recognized by the tax authority reduces taxable income and therefore reduces taxes. We must include the tax savings caused by depreciation deductions as a positive component in a project’s NPV.

Illustrative Steps:[2]

1. Determine the cost, C, of the asset net of any investment tax shield.

2. Determine the expected salvage value, Sn, of the asset sold in n years.

3. The depreciable amount is the net cost less the net salvage C – Sn.

4. Determine the years for depreciation: n. This is usually the number of years the asset is expected to be owned or the number of years of the asset’s useful life.

5. Under the straight-line method, the annual depreciation amount is equal to the depreciable amount divided by the years for depreciation, Dep = (C – Sn) ÷ n.

If an asset is sold for an amount greater than the undepreciated amount, then a recaptured depreciation is said to occur and the recaptured amount is considered to be taxable as regular income in the period in which it occurs. If an asset is sold for an amount less than the undepreciated amount, then a terminal loss is said to occur and the terminal loss reduces taxable income in the period in which it occurs. A recaptured depreciation results in an additional tax outflow (equal to the recaptured depreciation multiplied by the tax rate). A terminal loss results in a tax savings (equal to the terminal loss multiplied by the tax rate).

B. Capital Gains Tax

If the asset is sold for an amount greater than its initial cost, a capital gain is said to occur.

Capital Gain = Sales Price – Initial Cost = Sn – C

When adjusting for the tax effects of the asset sale, the capital gain is treated separately and the amount of the gain does not affect recaptured depreciation. Hence, at the time of the sale, the undepreciated amount of the asset is just reduced by the initial cost, C, which, if the asset had been depreciated, will result in a recaptured depreciation. The capital gain, though, results in an additional tax called a capital gains tax.

Capital Gains Tax = ½∙capital gain∙Tc

The present value of any anticipated capital gains tax is subtracted from the project’s NPV.

C. The Project’s Net Present Value (NPV)

The project’s NPV is the sum of the PV’s of all relevant cash inflows and outflows (including opportunity costs) caused by the project.

The following formula may help summarize the project’s NPV calculation.

NPV |= |- |initial cost |+ |PVincremental cash flows caused by the project* |+ |PVDepreciation Tax Shields |+ |PVSalvage Value or Expected Asset Sale Amount |- |PVCapital Gains Tax | |The incremental cash flows include revenues less expenses, opportunity costs, side effects, working capital changes, etc., all expressed after any relevant tax effects.

When doing capital budgeting analysis, two methods may be used. One, as illustrated in the NPV formula above, breaks apart the specific cash flows entering into the analysis and computes the PV of each separately. This may be optimal if not all the cash flows are of the same risk level. E.g., depreciation tax shields may be of lower risk than the revenue cash flows generated by a project, and thus the two types of cash flows should be discounted using two different risk-adjusted rates.

If all cash flows for a project are of the same risk, then the above method for calculating NPV may be used. An equivalent method that first determines each period’s aggregate net cash flow and then discounts the aggregated cash flows may also be used in this case. The aggregate cash flow method is not theoretically correct if not all cash flows are of the same risk.

-----------------------

[1] In Canada, CCA as prescribed by the Canada Customs and Revenue Agency (CCRA) is used for depreciating assets for tax purposes. See a Canadian reference for the specifics of annual CCA calculations.

[2] Note: the precise method for calculating depreciation deductions for tax purposes is more complicated and varies from country to country. The steps shown below are for the purposes of illustration only.

................
................

In order to avoid copyright disputes, this page is only a partial summary.

Google Online Preview   Download