UniversityofTexasatDallas

SchoolofManagement
Finance6301
CorporateFinance

ProfessorDay
Fall1999
Lecture5:CapitalBudgeting

TaxShieldsfromDepreciation
Theyearlydepreciationexpensefromwritingoffafirm'splantandequipmentisanexample
ofanexpensethatdoesnotaffectcashflow. Apartfromtaxconsequences,allofthecash
outflowassociatedwiththepurchaseofanydepreciableassetoccurswhentheassetisacquired.
Theassetisthenexpensedoveritsusefullife. Theconceptofmatchinganexpensewiththe
futurerevenuescreatedbythatassetisreferredtoinaccountingasthematchingprinciple.In
theanalysisofthefirm'sinvestmentdecisions,wefocusonthepresentvalueofthecashflows
from capital investment projects, rather than on the matching of historic costs with future
revenues. Consequently,ourdiscussionwillconcentrateondeterminingtheexacttimingof
future cash flows, with no explicit consideration (apart from the tax savings from the tax
deductionfordepreciation)tothematchingofexpenseswiththecashflowswhichtheygenerate.
Sincethefocusofouranalysisiscashflow,theimportanceofdepreciationexpensearises
fromthefactthatdepreciationexpensecanbeusedtoreducefuturetaxliabilitiesthroughthe
reduction of taxable income by an amount equal to depreciation expense. To illustrate the
impact of depreciation expense on cash flow, consider the following simplistic example.
Assumethatafirmhasrevenuesof$1000andacorporatetaxrateof34percent.Thefirmalso
has$200ofdepreciationexpense.Althoughcorporationsarecurrentlyallowedadeductionfor
depreciationexpensebytheInternalRevenueService,thetaxcodecanbechangedbyCongress
atanytime(retroactivelyinsomecases).Considerthefollowingcases.
I.DepreciationExpenseNotDeductibleasanExpense
CashFlow
Revenue
Taxes@34%

$1000
340

AfterTaxIncome

$660

Sincetherearenononcashexpendituresincludedabove,aftertaxrevenueisequaltocashflow.
II.DepreciationExpenseDeductible
CashFlow
Revenue

$1000

Depreciation
TaxableIncome
Taxes@34%
AfterTaxIncome
PlusDepreciation

200
$800
272
$528
200

CashFlow

$728

Whendepreciationexpenseistaxdeductible,cashflowincreasesby$68.Since
depreciationexpensereducestaxableincomeandtheresultingtaxliabilitywithoutcreatinga
matchingcashoutflow,cashflowisincreasedbythetaxsavings.Sincea$1deductionfor
depreciationexpensereducestaxableincomeby$1,andsincethetaxesontheadditionaldollar
ofrevenuewouldhavebeen$0.34(tc),anadditionaldollarofdepreciationincreasescashflow

by$0.34.Sincethedepreciationexpenseabovewas$200,andsinceeachdollarofdepreciation
expenseincreasescashflowby$034(thetaxliabilityononedollarofrevenue),theincreasein
cashflowattributabletothedeductionfordepreciationexpenseis$0.34x$200($68).
Ingeneral,thecashflowortaxshieldprovidedbydepreciationexpenseis
TaxShieldfromDepreciation=tcxDepreciationExpense
wheretc isthecorporatetaxrate. Therefore,giventherevenues(netofvariablecosts)and
depreciationexpenseintheaboveexample,
CashFlow =(1tc)xRevenue+tcxDepreciation
=(1.34)x$1000+.34x$200
=$728.

AnnualEquivalentCost
We often need to estimate the yearly fixed cost associated with the use of a piece of
equipment. Forexample, a meaningful estimate ofthe yearly fixed costs of manufacturing
capacityiscriticaltodeterminingtheunitcostsatagivenlevelofproduction.Toestimatethe
yearlyfixedcostsofproductioncapacity,weneedtodeterminethepresentvalueofthecoststhat
mustberecoveredovertheproductivelife(tobedistinguishedfromdepreciablelife)ofthe
machine. Giventhepresentvalueofthecoststhatmustberecovered,the annualequivalent
costisthelevelstreamofcosts(cashflows)havingapresentvalueequaltothepresentvalueof
thecostofacquisitionlessthepresentvalueofthetaxshieldsfromdepreciation.
Thepresentvalueofthecoststhatmustberecoveredovertheproductivelifeofanassetcan
bethoughtofintermsof
PurchasePricePresentValueofTaxShieldsfromDepreciation
Inaddition, wemightalsoneedto considerthe taxsavings fromany investmenttax credit
associatedwiththepurchaseoftheequipment,aswellasthepresentvalueofanyproceedsfrom
sellingtheassetattheendofitsusefullife.Thesecomplicationswillbeignoredforthemoment.
Toillustratetheconceptofannualequivalentcost,consideraleasingconcernthatpurchases
apieceofmanufacturingequipmentatacostof$10,000.Assumethatthemachinehasauseful
life of seven years but that Internal Revenue Service regulations permit the machine to be
depreciated over a five year life using straight line depreciation. Further, assume that the
purchaserisinthe40percenttaxbracketwitharequiredreturnof12percent. Theyearly
depreciationwillbe
YearlyDepreciation =,
=$2000,
givingyearlytaxsavings(positivecashflow)of$800(.40x$2000)peryearover5years.
Therefore,thepresentvalueofthetaxshieldsfromdepreciationwillbe
$2884=.40xx[].
Therefore,thepresentvalueofthecostswhichmustberecoveredbythelessoris
$7116

=$10,000$2,884.

Giventhatthemachineinourexamplehasausefullifeofsevenyearsandthatfixed
costsareincurredattheendoftheyear,wedefinetheannualequivalentcostforthemachineas
levelstreamofcostshavingthesamepresentvalueasthepresentvalueofthecoststobe
recovered
AECx[]

=$7116,

whichimpliesthat
AEC

=,
=$1559.

Sinceequipmentmustbepurchasedusingaftertaxdollarsandsincethetaxshieldsfrom
depreciationarebydefinitionaftertaxcashflows,thepresentvalueofthecoststhatmustbe
recoveredreflectsaftertaxdollars. Consequently,theannualequivalentcostmustalsobean
aftertaxcost.IfforsomereasonitismoreconvenienttothinkoftheAEConabeforetaxbasis,
theARCcanbegrossedupbyafactorof(1t c)todeterminetheequivalentbeforetaxamount,
$2598($1559/(1.40)).
MinimumAcceptableRentalPayments
Aproblemcloselyrelatedtotheannualequivalentcostisthedeterminingtheminimum
rentalpaymentthatalessormustchargeinleasingapieceofequipmenttothefinaluser(i.e.,the
lessee).Considerapieceofequipmentwhichthelessorpurchasesforthesolepurposeofleasing
totheactualuser.Inorderforthepurchaseoftheequipmenttobeapositivenetpresentvalue
project,thelessormustrequirethatthepresentvalueoftheaftertaxrentalpaymentsbeequalto
orgreaterthanthepresentvalueofthecostsassociatedwithacquiringtheasset.Astheactual
owneroftheequipment,thelessorisallowedtodeductdepreciationexpense.Theinformation
inthepreviousexamplecanbeusedtodeterminetheminimumrentalpaymentrequiredtolease
theequipment.
Sincerentalpaymentsareusuallydueinadvance,thepresentvalueoftheaftertax(fora
lessorina40percenttaxbracket)rentalpaymentsoverthenextsevenyearswouldbe
(1.40)xYearlyRentx[1+].
Notethattheterminbracketsintheexpressionaboverepresentstheannuityfactorforanannuity
of7paymentswherethefirstpaymentisdueimmediately.Thatisthefactorinbracketsisequal
to an immediate payment of one dollar plus the present value of a regular annuity of six
payments.
Giventhatthecostoftheassetnetofthepresentvalueofthetaxshieldsfromdepreciationis
$7116,theminimumbeforetaxrentalpaymentthatwouldberequiredis
RentalPayment

=,

=$2320.
Notethattheaftertaxvalueofyearlyrentalsof$2320tothelessoris$1392((1.40)x$2320).

Thetablebelowillustratesthetimingofthecashflowstothelessorfrompurchasingthe
machineatacostof$10,000,receivingthetaxshieldsfromdepreciation($800)duringeachyear
for5years,inadditiontoreceivingtheaftertaxrentalpaymentfor7years(withthefirstrental
dueimmediately).Computingthenetpresentvalueofthetotalcashflowstreamconfirmsthata
beforetaxrentalpaymentof$2320(givinganaftertaxyearlyrentalstreamof$1392)would
maketheacquisitionofthemachinewouldbeazeronetpresentvalueprospect.
CashFlowsforLeasedEquipment

CostofMachine

<$10,000>

TaxShieldsfrom
Depreciation(10/5)xtc
AfterTaxRentals

1392

800

800

800

800

800

1392

1392

1392

1392

1392

1392

TotalCashFlow

<$8608> $2192

$2192

$2192

$2192

$2192

$1392

CapitalBudgetingandNetPresentValue
Thetermcapitalbudgetingreferstotheproceduresthatareusedbyfirmstoallocatescarce
capitaltoinvestmentsinproductivecapacitythatareexpectedtogeneratecashflowsovera
givenfutureperiod.Whileeachcapitalinvestmentprojectisinsomesenseunique,acommon
setofprinciplescanbeusedtoapplythenetpresentvalueruletoawiderangeofinvestment
alternatives.Theseprinciplesareillustratedbytheexamplethatfollows.
Considerafirmhavinganopportunitytoproduceaproductwithalifecycleof5years.The
projectedsalesfortheprojectare$100,000peryearattheendofeachofthenext5years.The
beforetaxprofitmarginoneachdollarofsalesis10percent.Thefirmhasamarginaltaxrateof
40percentandarequiredrateofreturnof15percent.
Theproductionoftheproductinquestionwillrequirethepurchaseofmachineryatacostof
$10,000. Themachinerycanbedepreciatedover5yearsusingstraightlinedepreciation. In
addition,theprojectwillrequireaninvestmentininventoriesandaccountsreceivableswhich
mayreasonablybeexpectedtoberecoveredattheendof5years,whentheprojectterminates.
Althoughtherequiredinvestmentininventoryandreceivablesisnotknownatthepresenttime,
theindustrystandardsforinventoryturnoverandaccountsreceivableturnoverarerespectively6
timesperyearand12timesperyear.
RequiredInvestment
The first step in analyzing any capital investment project is to determine the required
investment.Asstatedabove,theprojectwillrequireanimmediateinvestmentof$10,000forthe
machineryrequiredtoproducetheproduct. Inaddition,theprojectwillrequireanimmediate
investmentininventoryandaccountsreceivable.
Therequiredinvestmentininventoryandreceivablesforthisprojectcanbedeterminedusing
estimatesofinventoryandreceivablesturnoverfortheindustry.Theinventoryturnoverratiois
givenby
InventoryTurnover

=.

Basedontheprojectedprofitmargin(10percent)andtheprojectedyearlysales,weknowthat
theyearlycostofgoodssoldwillbe$90,000.Sincetheindustrystandardforinventoryturnover
is6timesperyear,areasonableestimateoftheaverageinventoryrequiredfortheprojectis
AverageInventory

=
=
=$15,000.

Similarly, the required investment in accounts receivable can be determined from the
receivablesturnover
ReceivablesTurnover =.

Giventhatthereceivablesturnoverfortheindustryis12,theaveragelevelofaccounts
receivableswillbeapproximately
AverageReceivables =,
=,
=$8,333.
Sincethecostofgoodssoldisapproximately$0.90perdollarofsales(givenaprofitmarginof
10percent),theinvestmentrequiredtomaintainanaverageaccounts receivables balanceof
$8,333is$7,500(0.90x$8,333).
ProjectedCashFlows
Theanalysisaboveshowsthattheinvestmentinworkingcapitalthatisrequiredtosupport
theprojectis$22,500($15,000+$7,500).Thisamountisshownintheworksheetbelowasan
immediate(time0)cashoutflow. Wewillassumethatallinventoriesaresoldandthatall
receivablesarecollectedwhentheprojectisliquidated.Thisassumptionimpliesthattherewill
beanadditionalcashinflowof$22,500whentheprojectisterminatedattheendofyear5.
Themachinerypurchasedatacostof$10,000canbedepreciatedover5yearsusingstraight
line depreciation. Given that the firm's tax rate is 40 percent, the yearly tax shields from
depreciationwillbe
.40x

=$800.

Theaftertaxcashflowgeneratedbythesalesrevenuefromtheprojectwillbe
(1tc)xProfitMarginxSales =(1.40)x.10x$100,000,
=$6,000.
Although we could have computed a separate cash flow statement for each year of the
project'slife,itisoftenmoreconvenienttodeterminetheaftertaxcashflowforeachcomponent
oftheprojectseparately.Forexample,intheworksheetonthefollowingpage,thetaxshields
fromdepreciationandtheaftertaxprofitmarginonsalesrevenues(i.e.,netofcostofgoods
sold)areshownonseparatelines.

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Thecashflowsfortheprojectaresummarizedinthefollowingworksheet.

ProjectCashFlows

WorkingCapital

<$22,500>

Machinery

<$10,000>

InvTaxCredit

TaxShieldsfrom
Depreciation(40/8)xc
AfterTaxProfitonSales
[Salesx.90x(1c)]
CashFlow

$22,500

800

800

800

800

800

6000

6000

6000

6000

6000

<$32,500>

$6800

$6800

$6800

$6800

$6800
+$22500

Givenarequiredrateofreturnof15percent,thenetpresentvaluefortheprojectwillbe
NPV

=<$32,500>+$6,800[]+,
=$1481.

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AnnualEquivalentCostandReplacementDecisions
Thephysicallifeofapieceofequipmentisthemaximumlengthoftimethattheequipment
canbeoperatedgiventhewillingnesstoincurexcessivecostsofmaintenanceanddowntime.
Forexample,mostautomobilescanbeoperatedfor10yearsormorewithenoughmaintenance
and loss of use due to time in the repair shop. The economic life of an asset is to be
distinguishedfromthephysicallifeinthattheeconomiclifeofapieceofequipmentistheusage
periodhavingthelowestyearlyequivalent(rental)cost.
Tounderstandthedistinctionbetweenphysicallifeandeconomiclifemoreclearly,consider
thefollowingexample.Aparticularpieceofmanufacturingequipmenthasaphysicallifeof3
yearsandaninitialcostof$9000. Thefirmhasacorporatetaxrateof331/3percentanda
required rate ofreturn of10 percent. The machine will require increasing expenditures on
maintenance(withallexpendituresoccurringattheendoftheyear)andmaybesalvagedatany
timepriortotheendofthethirdyear. Therequiredmaintenancecosts(beforetax)andthe
prospectiveaftertaxsalvagevaluesforthemachinearegivenbelow.Notethatifthemachineis
usedforthreeyearsthenthecashflowgeneratedbythesalvageofthemachineisassumedtobe
zero.Further,therewillbenomaintenancecostsattheendofanyyearinwhichthemachineis
retiredfromservice.
Year
1
2
3

BeforeTax
Maintenance

AfterTax
Salvage

$1800
$3000

$5000
$4000
0

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ThreeYearReplacementCycle
Thepresentvalueofthecostsassociatedwithusingthemachineoveritsentirephysicallife
ofthreeyearsincludesthepurchasepriceof$9000,theyearlytaxshieldsfromdepreciationover
thenextthreeyears(.333x$9000/3),andaftertaxmaintenancecostsof$1200(2/3x$1800)
attheendofyearoneand$2000(2/3x$3000)attheendofyeartwo.Thepresentvalueof
thesecostsis
NPV

=<$9000>+[]
++,
=<$9257>.

Inordertocomparethecostofreplacingthemachineeverythreeyearswiththe(mutually
exclusivealternative)costofreplacingthemachinemorefrequently,itisusefultoconvertthe
presentvalueofthetotalcashoutflowsgivenabovetoaconstantaftertaxyearly(rental)cost
havingthesamepresentvalue.Thislevelstreamofrentalcostsisusuallyreferredastheannual
equivalentrentalcost.Aswillbecomeapparentinthenextexample,itisconvenienttoassume
that the firstaftertaxrentalpaymentisdueimmediately (i.e.,inadvance). Giventhis
assumption,theannualequivalentrentalcostoverathreeyearreplacementcycleis
AnnualEquivalentRental

=,
=
=<$3384>.

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TwoYearReplacementCycle
Theeconomiclifeofthismachineislessthanthreeyearsifthereisashorter(morefrequent)
replacementcyclewithaloweraftertaxyearlyequivalentcostofoperation.Theprocedureused
todeterminetheannualequivalentrentaloveratwoyearreplacementcycleissimilartothe
procedureabove. However,thepresentvalueofthecashflowsoveratwoyearreplacement
cycleincludesthetaxshieldsfromdepreciationforonlythefirsttwoyears.Further,sincethe
machinewillbesoldattheendofthesecondyear,thepresentvalueofmaintenancecostsinthe
secondyearmustbereplacedbythepresentvalueoftheaftertaxproceedsfromsellingthe
machineattheendofyeartwo. Thepresentvalueofthecostsassociatedwithatwoyear
replacementcycleis
NPV

=<$9000>+[]
++,
=<$5050>.

Theannualequivalentrentalcostoveratwoyearreplacementcycleis
AnnualEquivalentRental

=,
=
=<$2645>,

whichindicatesthattheyearlycostofusingthemachineoveratwoyearreplacementcycleis
lessthantheyearlycostofusingthemachineoverathreeyearreplacementcycle. Inother
words,theeconomiclifeofthemachinecannotbethreeyearssincetheyearlycostofreplacing
themachineeverytwoyearsislessthantheyearlycostofreplacingthemachineeverythree
years.
OneYearReplacementCycle
Toshowthattheeconomiclifeofthemachineistwoyears,wemustshowthattheannual
equivalentcostofreplacingthemachineeveryyearisgreaterthantheannualequivalentcostof
replacingthemachineeverytwoyears.Assumingthatthemachineisreplacedattheendofthe
firstyear,thenetpresentvalueoftheassociatedcashflowsis
NPV

=<$9000>++,
=<$3545>,

14

whichisalsotheannualequivalentrentalcorrespondingtoastrategyofreplacingthemachine
every year. Since this yearly cost ($3545) is greater than the yearly cost of replacing the
machineeverytwoyears($2645),themachinehasaneconomiclifeoftwoyears.

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ReplacementDecisions
The conversion of the present value of the cash flows associated with using a piece of
equipmentoveritseconomiclifetoanannualequivalentrentalpaymentisparticularlyusefulin
evaluatingthedecisiontoreplacethe(old)equipmentcurrentlyinusewithamorerecentmodel.
In most cases, the newer model can be operated at lower per unit costs, with substantially
reducedmaintenancecosts.
Theuseofannualequivalentcostsinreplacementdecisionsisillustratedbythefollowing
example. Considerafirmhavinganopportunitycostofcapitalof10percentwhichis(for
simplicity)exemptfrompayingcorporatetaxes.Thefirmhasanopportunitytoreplaceapiece
of equipment currently in service with a newer model having a cost of $7000. The new
equipment, which has an economic life of 5 years, will require maintenance (an overhaul)
costing$1200attheendofeachofthenext4years.
Thepresentvalueofthecostsofusingthenewmachineoverthenext5yearsis
NPV

=<$7000>+<$1200>[],
=<$10,804>.

Notethatifcorporatetaxeswereincludedinouranalysis,thepresentvalueofthecostsofusing
thenewmachinewouldincludethetaxshieldsfromdepreciationandthemaintenancecosts
wouldbeconvertedtoanaftertaxbasis.
Theequivalentannualrentalcostofusingthenewmachineis
AnnualEquivalentRental

=,
=<$2591>.

Therefore,thetotalrentalcostofusingthenewmachineis$2591peryear.
YearlyCostforExistingEquipment
To determine whether new equipment should be purchased to replace the equipment
currentlyinservice,assumethattheschedulefortherequiredmaintenancecostsandpotential
salvagevalues fortheoldequipment(beginningimmediately)overthenexttwoyearsisas
shownbelow
Year

Maintenance

Salvage

$1000

$3000

16

1
2

1500

2000
800

Thesalvagevaluefortheoldequipmentiscrucialinanyreplacementdecisionsincerunningthe
oldequipmentforonemoreyearasofanyfuturedecisionpointforcesthefirmtogiveupthe
opportunitytoselltheoldequipmentatthesalvagevaluelistedabove.

17

Inordertodeterminewhethertheoldmachineshouldbereplaced,wecancomparethe
presentvalueofthecostsofrunningtheexistingmachineonemoreyearwiththeequivalent
yearlyrentalcostofoperatingthenewmachine.Sincetheequivalentannualrentalcosthasbeen
determinedundertheassumptionthatthefirstpaymentisdueimmediately,theequivalentrental
costshouldbecomparedwiththepresentvalueofthecostsofusingtheoldequipmentforone
moreyear.Thepresentvalueofthecostsofusingtheoldequipmentforonemoreyearinclude
$1000ofmaintenancerequiredtooperatetheequipmentforanadditionalyearplusthe
opportunitycostofnotsalvagingtheoldequipmentimmediately($3000)minusthepresent
valueoftheproceedsfromsalvagingtheoldequipmentnextyear(whenthenewequipmentis
purchased).(Notethatweareimplicitlyassumingthattheoldmachinecanbereplacedinone
yearattoday'scosts.)
Thepresentvalueofthecostsofoperatingtheexistingmachineonemoreyeararecurrently
$2182

=$1000+$3000.

Sincethecostofusingtheoldmachineonemoreyearisonly$2182,comparedwithayearly
costofusingthenewmachineof$2591,weshouldusetheoldequipmentforonemoreyear.
Attheendofoneyear,thedecisiontousetheoldequipmentforonemoreyearwillrequire
that the firm spend $1500 for maintenance and give up the opportunity to salvage the old
machinefor$2000.Thesecostswillbeoffsetinpartbythepresentvalueoftheproceedsfrom
salvagingtheoldequipmentattheendoftheyearfor$800.Therefore,thepresentvalueofthe
costsofoperatingtheexistingmachineonemoreyeararecurrently
$2773

=$1500+$2000.

Assumingthattheannualequivalentcostofusingthenewmachinehasremainedat$2591,
theoldmachineshouldbereplacedsincethecostofusingtheoldmachineforasecondyearis
$2773.Ifthecostsofusingthenewequipmentarenotexpectedtoremainconstant,wecould
alwaysfactorthisintoourdecisionbyincludingthepresentvalueoftheincreaseinthecostsof
usingthenewmachineasoneofthecomponentsofthecostofusingtheoldmachineforone
moreyearasoftheinitialdate(i.e.,datezero). Inotherwords,wecouldtreattheprojected
increaseinthecostofnewequipmentrepresentsasanopportunitycostofusingtheoldmachine.

18