Principles of Financial Analysis FIN 3250 Lecture Notes PDF

Principles of Financial Analysis FIN 3250 Dr. Lu Wang Silberman College of Business Ch. 2 Financial Statements and Long-term Financial Planning Learning Objective Understand the difference between accounting value (or book value) and market value. Know the differen...

Principles of Financial Analysis FIN 3250 Dr. Lu Wang Silberman College of Business Ch. 2 Financial Statements and Long-term Financial Planning Learning Objective Understand the difference between accounting value (or book value) and market value. Know the difference between accounting income and cash flow. Know how to determine a firm’s cash flow from its financial statements. Understand the difference between average and marginal tax rates. Understand the basics of Capital Cost Allowance (CCA) and Undepreciated Capital Cost (UCC). Ch. 2 Financial Statements and Long-term Financial Planning Chapter Outline Statement of Financial Position Statement of Comprehensive Income Cash Flow Taxes Capital Cost Allowance Summary and Conclusions Ch. 2 Financial Statements and Long-term Financial Planning Statement of Financial Position (Balance Sheet) The statement of financial position is a snapshot of the firm’s assets and liabilities at a given point in time Assets are listed in order of liquidity Ease of conversion to cash Without significant loss of value Statement of Financial Position Identity Assets = Liabilities + Stockholders’ Equity Ch. 2 Financial Statements and Long-term Financial Planning Statement of Financial Position (Balance Sheet) Canadian Enterprises Limited Balance Sheet Ch. 2 Financial Statements and Long-term Financial Planning Statement of Financial Position (Balance Sheet) Ch. 2 Financial Statements and Long-term Financial Planning Statement of Financial Position (Balance Sheet)---Net Working Capital Current Assets subtract Current Liabilities Positive when the cash that will be received over the next 12 months exceeds the cash that will be paid out Usually positive in a healthy firm Ch. 2 Financial Statements and Long-term Financial Planning Statement of Financial Position (Balance Sheet)---Net Working Capital What is the net working capital of Canadian Enterprise Limited of 2014? Ch. 2 Financial Statements and Long-term Financial Planning Statement of Financial Position (Balance Sheet)---Net Working Capital What is the net working capital of Canadian Enterprise Limited in 2014? 2014 Current assets=$1,112 - Current liabilities=$428 Net working capital=$684 Ch. 2 Financial Statements and Long-term Financial Planning Statement of Financial Position (Balance Sheet)---Liquidity Ability to convert to cash quickly without a significant loss in value Liquid firms are less likely to experience financial distress However, liquid assets earn a lower return Tradeoff between liquid and illiquid assets Ch. 2 Financial Statements and Long-term Financial Planning Statement of Financial Position (Balance Sheet)---Debt vs. Equity Equity holders are only entitled to the residual value, the portion left after creditors are paid. Shareholders’ equity= Assets-Liabilities The use of debt in a firm’s capital is called financial leverage. Financial leverage magnify both gains and losses, aka, increases firms’ risk. Ch. 2 Financial Statements and Long-term Financial Planning Statement of Financial Position (Balance Sheet)---Debt vs. Equity Financial leverage magnify both gains and losses, aka, increases firms’ risk. Source: academlib.com Ch. 2 Financial Statements and Long-term Financial Planning Statement of Financial Position (Balance Sheet)---Debt vs. Equity What is the total equity of Canadian Enterprises Limited? What is the long term financing amount of Canadian Enterprises Limited? Ch. 2 Financial Statements and Long-term Financial Planning Statement of Financial Position (Balance Sheet)---Debt vs. Equity What is the total equity of Canadian Enterprises Limited in 2015? Owner’s equity=Common shares + Retained earnings =$640+1,629=$2,269 What is the long term financing amount of Canadian Enterprises Limited in 2015? Long term financing= Long term debt + Owner’s equity = $454+2,269=$2,723 Ch. 2 Financial Statements and Long-term Financial Planning Statement of Financial Position (Balance Sheet)---International Financial Reporting Standards (IFRS) IFRS allows companies to use the historical cost method Also allows use of the revaluation (fair value) method All items in an asset class should be revalued simultaneously Revaluation should be performed with enough regularity to ensure that the carrying amount is not materially different from the fair value Ch. 2 Financial Statements and Long-term Financial Planning Statement of Financial Position (Balance Sheet)---Value vs. Cost The statement of financial position provides the book value of the assets, liabilities and equity. Market value is the price at which the assets, liabilities or equity can actually be bought or sold. Market value and book value are often very different. Why? Which is more important to the decision-making process? Ch. 2 Financial Statements and Long-term Financial Planning Statement of Financial Position (Balance Sheet)---Value versus Cost Ch. 2 Financial Statements and Long-term Financial Planning Statement of Comprehensive Income (Income Statement) The statement of comprehensive income summarizes a firm’s performance over a period of time. Also called income statement. Revenues-Expenses=Income You generally report revenues first and then deduct any expenses for the period Ch. 2 Financial Statements and Long-term Financial Planning Statement of Comprehensive Income (Income Statement) Ch. 2 Financial Statements and Long-term Financial Planning Statement of Comprehensive Income (Income Statement) Net income is often expressed on a per-share basis and called earning per share (EPS) A good indicator for stock selection! Suppose that Canadian Enterprises had 200 million shares outstanding at the end of 2015. What was its EPS? What was the dividend per share? Ch. 2 Financial Statements and Long-term Financial Planning Statement of Comprehensive Income (Income Statement) What was its EPS of Canadian Enterprise? What was the dividend per share? Ch. 2 Financial Statements and Long-term Financial Planning Statement of Comprehensive Income (Income Statement) What was its EPS of Canadian Enterprise? Net income/ shares outstanding =$374/200=$1.87 per share What was the dividend per share? Dividend/outstanding shares =$65/200=$.325 per share Ch. 2 Financial Statements and Long-term Financial Planning Statement of Comprehensive Income (Income Statement) Non-cash items: Expenses charged against revenues that do not directly affect cash flow. (This is why accounting income differs from cash flow) Why depreciation is a Non-cash item? The actual cash outflow happened before the amount shows on the income statement. The revenue associated with the cash outflow actually happens during a length of time after the cash outflow. Ch. 2 Financial Statements and Long-term Financial Planning Statement of Comprehensive Income (Income Statement) Time vs cost From the income statement and balance sheet, we want to find more information about different kinds of costs (calculate cash flows). Whether the cost related to short run (variable cost) or long run (fixed cost) Ch. 2 Financial Statements and Long-term Financial Planning Statement of Comprehensive Income (Income Statement) Publicly traded companies must file regular reports with the Ontario Securities Commission These reports are usually filed electronically and can be searched at the SEDAR site www.sedar.com Ch. 2 Financial Statements and Long-term Financial Planning Cash Flow Cash flow is one of the most important pieces of information that a financial manager can derive from financial statements (it teaches you how the business is running). We will look at how cash is generated from utilizing assets and how it is paid to those that finance the purchase of the assets. Ch. 2 Financial Statements and Long-term Financial Planning Cash Flow Cash Flow From Assets (CFFA) = Cash Flow to Bondholders + Cash Flow to Shareholders Ch. 2 Financial Statements and Long-term Financial Planning Cash Flow Cash Flow From Assets = cash flow to bondholders + cash flow to shareholders= operating cash flow - capital spending - additional to net working capital So you know where the money has been spent on. Ch. 2 Financial Statements and Long-term Financial Planning Cash Flow Operating cash flow refers to the cash flow that results from the firm’s day-to-day activities of producing and selling. Should firm’s financing be included? Why? Capital spending refers to the net spending on fixed assets ( purchase of fixed assets-sales of fixed assets) Additions to net working capital is the amount spent on net working capital (current assets-current liabilities) Ch. 2 Financial Statements and Long-term Financial Planning Cash Flow---Cash Flow from Assets-- Operating Cash Flow Operating cash flow is the cash generated from a firm’s normal business activities. We want to calculate revenues minus costs, but we do not want to include depreciation since it’s not a cash flow, and we do not want to include interest because it’s financing expense. Ch. 2 Financial Statements and Long-term Financial Planning Cash Flow---Operating Cash Flow Ch. 2 Financial Statements and Long-term Financial Planning Cash Flow---Operating Cash Flow What was the operating cash of Canadian Enterprises in 2015? Canadian Enterprises 2015 Operating Cash Flow Earnings before $694 interest and taxes +Depreciation 65 -Taxes 250 Operating cash $509 flow Ch. 2 Financial Statements and Long-term Financial Planning Cash Flow---Operating Cash Flow (OCF) Fergus Inc. has sales of $39,500, costs of $18,400, depreciation expense of $1,900, and interest expense of $1400. If the tax rate is 35 percent, what is the operating cash flow (OCF)? Ch. 2 Financial Statements and Long-term Financial Planning Cash Flow---Operating Cash Flow What was the operating cash flow of Fergus Inc.? Fergus Inc. Income Statement Sales $39500 Costs -$18400 Depreciation -$1900 Earnings before interest $19200 and taxes Interest Paid -$1400 Income before taxes $17800 Taxes -$6230 ($17800*0.35) Net income $11570 Ch. 2 Financial Statements and Long-term Financial Planning Cash Flow---Operating Cash Flow What was the operating cash flow of Fergus Inc.? Fergus Inc. operating cash flow Earnings before interest $19200 and taxes Depreciation +$1900 Taxes -$6230 Operating cash flow $14870 Ch. 2 Financial Statements and Long-term Financial Planning Cash Flow---Capital Spending Capital spending is the money spent on fixed assets less the money received from the sale of fixed assets. Ch. 2 Financial Statements and Long-term Financial Planning Cash Flow---Capital Spending What’s Canadian Enterprise’s capital spending in 2015? Let’s look at its statement of financial position. Ending fixed assets $1,709 (from year 2015) -Beginning fixed assets 1,644 (from year 2014) +depreciation 65 Net investment in fixed $130 assets/capital spending Ch. 2 Financial Statements and Long-term Financial Planning Cash Flow---Capital Spending Can net capital spending be negative? Why? Ch. 2 Financial Statements and Long-term Financial Planning Cash Flow---Capital Spending Can net capital spending be negative? Why? This would happen if the firm sold more assets than it purchased. Ch. 2 Financial Statements and Long-term Financial Planning Cash Flow---Change in Net Working Capital Change in Net Working Capital is net investment in net working capital (the change in the differences between current assets and current liabilities) Ch. 2 Financial Statements and Long-term Financial Planning Cash Flow---Change in Net Working Capital What is Canadian Enterprise’s Change in net working capital (NWC)? Let’s go back to its statement of financial position. 2015 NWC= 2015 current assets-2015 current liabilities=$1,403-389=$1,104 2014 NWC= 2014 current assets-2014 current liabilities=$1,112-428=$684 Ch. 2 Financial Statements and Long-term Financial Planning Cash Flow---Change in Net Working Capital What is Canadian Enterprise’s Change in net working capital (NWC)? Ending NWC $1,014 -Beginning NWC 684 Change in NWC $330 Ch. 2 Financial Statements and Long-term Financial Planning Cash Flow---Cash Flow from Assets What is Canadian Enterprise’s cash flow from assets? Canadian Enterprises 2015 Cash Flow from Assets Operating cash flow $509 -Net capital spending 130 -Changes in NWC 330 Cash flow from assets $49 Ch. 2 Financial Statements and Long-term Financial Planning Cash Flow---Cash Flow from Assets Another name for cash flow from assets is Free Cash Flow, referring to cash that the firm is free to distribute to creditors and shareholders because it is not needed for reinvestment. Ch. 2 Financial Statements and Long-term Financial Planning Cash Flow---Cash Flow to Creditors and Shareholders Cash flow to creditors: a firm’s interest payments to creditors less net new borrowings. Cash flow to shareholders: Dividends paid out by a firm less net new equity raised. Ch. 2 Financial Statements and Long-term Financial Planning Cash Flow---Cash Flow to Creditors and Shareholders What is Canadian Enterprises’ cash flow to creditors in 2015? Let’s look at its statement of comprehensive income. Interest paid=$70 Let’s look at the statement of financial position for net new borrowing. In 2015, long-term debt=$454; in 2014, long-term debt= $408. New borrowing in 2015=$454-$408=$46 Ch. 2 Financial Statements and Long-term Financial Planning Cash Flow---Cash Flow to Creditors and Shareholders What is Canadian Enterprises’ cash flow to creditors in 2015? Canadian Enterprises 2015 Cash flow to Creditors Interest Paid $70 -Net new borrowing 46 Cash flow to creditors $24 Ch. 2 Financial Statements and Long-term Financial Planning Cash Flow---Cash Flow to Creditors and Shareholders What is Canadian Enterprises’ cash flow to shareholders in 2015? Let’s look at its statement of comprehensive income. Dividend paid=$65 Let’s look at the statement of financial position for net new equity. In 2015, common shares=$640; in 2014, common shares= $600. net new equity in 2015=$640--$600=$40 Ch. 2 Financial Statements and Long-term Financial Planning Cash Flow---Cash Flow to Creditors and Shareholders What is Canadian Enterprises’ cash flow to shareholders in 2015? Canadian Enterprises 2015 Cash flow to Shareholders Dividends Paid $65 -Net new equity 40 Cash flow to shareholders $25 Ch. 2 Financial Statements and Long-term Financial Planning Cash Flow---Import Observation Operating cash flow, defined as earnings before interest and depreciation minus taxes, should usually be positive if a firm generates enough cash to pay operating costs. Total cash flow is (operating cash flow-capital spending-NWC changes) frequently be negative if a firm’s spending on inventory and fixed assets is higher than cash flow from sales. Ch. 2 Financial Statements and Long-term Financial Planning Cash Flow---Summary Ch. 2 Financial Statements and Long-term Financial Planning Cash Flow---Example Dole Cola 2015 Statement of Comprehensive Income ($millions) Net Sales $600 Costs of goods sold 300 Depreciation 150 EBIT $150 Interest Paid 30 Taxable income $120 Taxes 48 Net income $72 Retained earnings $42 Dividends 30 Ch. 2 Financial Statements and Long-term Financial Planning Cash Flow---Dole Cola operating cash flow Ch. 2 Financial Statements and Long-term Financial Planning Cash Flow---Dole Cola operating cash flow Dole Cola 2015 Operating Cash Flow ($millions) EBIT $150 +Depreciation 150 -Taxes 48 Operating cash flow $252 Ch. 2 Financial Statements and Long-term Financial Planning Cash Flow---Dole Cola net capital spending Suppose Beginning of fixed asset of 2014=$500mil and endo of 2015 fixed asset=$750 mil Ch. 2 Financial Statements and Long-term Financial Planning Cash Flow---Dole Cola net capital spending Ending fixed assets $750 (from year 2015) -Beginning fixed assets 500 (from year 2014) +depreciation 150 Net investment in fixed $400 assets Ch. 2 Financial Statements and Long-term Financial Planning Cash Flow---Dole Cola change in NWC Ending NWC $550 -Beginning NWC 510 Change in NWC $40 Ch. 2 Financial Statements and Long-term Financial Planning Cash Flow---Cash flow from assets Dole Cola 2015 Cash Flow from Assets Operating cash flow $252 -Net capital spending 400 -Changes in NWC 40 Cash flow from assets -$188 Ch. 2 Financial Statements and Long-term Financial Planning Cash Flow---Cash flow to shareholders Suppose that there is no new equity in 2015. Dole Cola 2015 Cash flow to Shareholders Dividends Paid $30 -Net new equity 0 Cash flow to $30 Shareholders Ch. 2 Financial Statements and Long-term Financial Planning Cash Flow---Cash flow to bondholders Cash flow from assets=cash flow to shareholders + cash flow to bondholders. Cash flow to bondholders = cash flow from assets – cash flow to share holders Cash flow to bondholders= -$188-$30= -$218 Net new borrowing=Cash flow to bondholders- Interest paid = -$218-$30=-$248 Ch. 2 Financial Statements and Long-term Financial Planning Cash Flow---Cash flow to bondholders Dole Cola 2015 Cash flow to Creditors Interest Paid $30 -Net new borrowing -248 Cash flow to bondholders -$218 Ch. 2 Financial Statements and Long-term Financial Planning Taxes---Individual vs Corporate Tax Rate Tax Rate Taxable Income - 2017 Brackets Federal 15% up to $45,916 20.5% $45,916 up to $91,831 26% $91,831 up to $142,353 29% $142,353 up to $202,800 33% $202,800 and over BC 5.06% up to $38,898 7.70% $38,898.01 to $77,797 10.50% $77,797.01 to $89,320 12.29% $89,320.01 to $108,460 14.70% Over $108,460 Ch. 2 Financial Statements and Long-term Financial Planning Taxes---Individual Tax Rate The rate apply to income from employment (wages and salaries) and from unincorporated businesses. In BC, suppose your annual salary is $75,000, what is your tax rate on the next dollar? Marginal tax rate of $75,000=federal rate +provincial rate=20.5%+7.7%=28.2% Ch. 2 Financial Statements and Long-term Financial Planning Taxes---Average vs Marginal tax rate Average tax rate: Total taxes paid divided by total taxable income. Marginal tax rate: Amount of tax payable on the next dollar earned. Ch. 2 Financial Statements and Long-term Financial Planning Taxes---Average vs Marginal tax rate What is the average tax rate of an annual income $75,000? Ch. 2 Financial Statements and Long-term Financial Planning Taxes---Average vs Marginal tax rate What is the average tax rate of an annual income $75,000? Federal tax=$45,916*15%+($75,000- $45,916)*20.5%=$12,849.62 BC tax=$38,898*5.06%+($75,000- $38,898)*7.7%=$4,958.142 Average tax rate =($12,849.62+$4,958.142)/$75,000=23.74% Ch. 2 Financial Statements and Long-term Financial Planning Taxes---Taxes on Investment Gains When an investor holds stocks, they are subject to two types of taxes:  Dividend tax credit – A tax formula that reduces the effective tax rate on dividends  Capital gains tax – Tax is paid on the investment’s increase in value over its purchase price Ch. 2 Financial Statements and Long-term Financial Planning Taxes---Taxes on Investment Gains Dividend tax credit  Double taxation: corporation has already used after tax income paid for dividend, and dividends to individual investors have be taxed again.  Dividend tax credits only apply to dividend paid by Canadian companies. Ch. 2 Financial Statements and Long-term Financial Planning Taxes---Taxes on Investment Gains Capital gains  Arise when an investment increases in value above its purchase price. In Canada, taxes apply at 50% of the applicable marginal rate.  Individuals only pay taxes on realized capital gains. For example, for stock holders, only when the stocks are sold. Ch. 2 Financial Statements and Long-term Financial Planning Taxes---Taxes on Investment Gains For example, according to personal tax brackets in BC, a person’s income is at highest bracket, what’s the nominal tax rate for his additional investment gains? Ch. 2 Financial Statements and Long-term Financial Planning Taxes---Corporate Taxes Interest is a tax-deductible expense. Debt financing has a tax advantage over financing with common shares. Why? Ch. 2 Financial Statements and Long-term Financial Planning Taxes---Corporate Taxes Interest is a tax-deductible expense, debt financing has a tax advantage over financing with common shares. Why? Interest paid is deducted from EBIT in calculating taxable income but dividends paid are not. Ch. 2 Financial Statements and Long-term Financial Planning Taxes---Global Tax Rates Individual and corporate tax rates vary in different countries. The ways of calculating taxable incomes are different too. Individuals and companies can from high-taxing nations can enjoy the opportunity by moving their wealth or corporations to low-taxing nations. Ch. 2 Financial Statements and Long-term Financial Planning Taxes---Capital Gains and Carry-forward and Carry-back Loss carry-back Using a year’s capital loss to offset capital gains of previous years. Loss carry-forward Using a year’s capital loss to offset capital gains of future years. Ch. 2 Financial Statements and Long-term Financial Planning Taxes---Capital Gains and Carry-forward and Carry-back Loss carry-back If capital losses exceed capital gains, the net capital loss may be carried back to reduce taxable capital gains in the three prior years. How much could Canadian Enterprises carry back? 2012 2013 2014 2015 Gain(loss) $150,000 $200,000 $300,000 - $1,000,000 Ch. 2 Financial Statements and Long-term Financial Planning Taxes---Capital Gains and Carry-forward and Carry-back Loss carry-back If capital losses exceed capital gains, the net capital loss may be carried back to reduce taxable capital gains in the three prior years. How much could Canadian Enterprises carry back? ($300,000+$200,000+$150,000)=$650,000 Canadian Enterprises can carry back $650,000 to get refund for its taxes paid last three years. Ch. 2 Financial Statements and Long-term Financial Planning Taxes---Capital Gains and Carry-forward and Carry-back Loss carry-forward If capital losses exceed capital gains, the net capital loss may be carried forward to reduce taxable capital gains in the next seven years. How much can Canadian Enterprises carry forward? $1,000,000-$650,000=$350,000 Canadian Enterprises can carry forward the remaining, $350,000 to get deduct on its taxes to pay in the next seven years. Ch. 2 Financial Statements and Long-term Financial Planning Taxes---Capital Cost Allowance CCA is depreciation for tax purposes. CCA is deducted before taxes and acts as a tax shield. Every capital asset is assigned to a specific asset class by the government. Every asset class is given a depreciation method and rate. Half-year Rule – In the first year, only half of the asset’s cost can be used for CCA purposes. Ch. 2 Financial Statements and Long-term Financial Planning Taxes---Capital Cost Allowance (CCA) Some CCA rates Ch. 2 Financial Statements and Long-term Financial Planning Taxes---Capital Cost Allowance (CCA) ABC Corporation purchased $100,000 worth of photocopiers in 2015. Photocopiers fall under asset class 8 with a CCA rate of 20%. How much CCA will be claimed in 2015 and 2016? Ch. 2 Financial Statements and Long-term Financial Planning Taxes---Capital Cost Allowance (CCA) Ch. 2 Financial Statements and Long-term Financial Planning Taxes---Capital Cost Allowance (CCA) Undepreciated Capital Cost (UCC) The ending book value of the asset after deduction of CCA. An example: A company bought a $30,000 Van. Calculate the CCA of the Van for the next five years. Ch. 2 Financial Statements and Long-term Financial Planning Taxes---Capital Cost Allowance (CCA) An example: A company bought a $30,000 Van. Calculate the CCA of the Van for the next five years. Year Beginning CCA Ending UCC UCC 1 $15,000 $4500 $10,500 ($30,000*50 ($15,000*30 ($15,000- %) %) 4,500) 2 25,500 7,650 17,850 (10,500+15, ($25,500- 000) 7,650) 3 17,850 5,355 12,495 4 12,495 3,749 8,747 5 8,747 2,624 6,123 Ch. 2 Financial Statements and Long-term Financial Planning Taxes---Capital Cost Allowance (CCA)--- Incentive in Practice Larger CCA rates reduce taxes and increases cash flows. An example: An increase in CCA rates from 20 to 30 percent for manufacturing and processing assets. The combined federal/ provincial corporate tax rate on this sector is 26.5%. Suppose Company A was planning to purchase a new processing equipment at $ 1million. How much additional tax will Company A save due to the new tax rule in the first year the equipment is put into use? Ch. 2 Financial Statements and Long-term Financial Planning Taxes---Capital Cost Allowance (CCA)--- Incentive in Practice Larger CCA rates reduce taxes and increases cash flows. Under half-year rule, UCC for the first year is 0.50*$1 million=$500,000. Old rate: CCA=0.20*$500,000=$100,000 New rate: CCA= 0.30*$500,000=$150,000 Firms deduct CCA in the figuring taxable income, taxable income will be reduced by ($150,000-100,000)=$50,000. Company A’s tax bill will be dropped by $50,000*0.265=$13,250 Ch. 2 Financial Statements and Long-term Financial Planning Taxes---Capital Cost Allowance (CCA)---Asset purchases and sales What about firms have sales and purchases both in a give class? In this case, we apply net acquisitions rule. When an asset is sold, the asset class is reduced by the realized value of the asset, or by its original cost, whichever is less. Ch. 2 Financial Statements and Long-term Financial Planning Taxes---Capital Cost Allowance (CCA)---Asset purchases and sales Net acquisition rule: An example Following the previous van purchase example, suppose during the third year, the firm decides to dispose of the van and buy a new truck. They sell the van for $15,000, and the new truck costs $50,000. The net acquisitions of year 3 are $35,000. Show the 5-year CCA. Ch. 2 Financial Statements and Long-term Financial Planning Taxes---Capital Cost Allowance (CCA)---Asset purchases and sales Net acquisition rule: An example Year Beginning CCA Ending UCC UCC 1 $15,000 $4500 $10,500 ($30,000*50 ($15,000*30 ($15,000- %) %) 4,500) 2 25,500 7,650 17,850 (10,500+15,0 ($25,500- 00) 7,650) 3 35,350 10,605 24,745 (17,850+17,5 00) 4 42,245 12,674 29,571 Ch. 2 Financial Statements and Long-term Financial Planning Taxes---Capital Cost Allowance (CCA)--- Closing an Asset Class When the last asset in an asset class is sold, the asset class is terminated. This can result in a terminal loss or recaptured CCA. Terminal Loss – The difference between the UCC and the adjusted cost of disposal when the UCC is greater. Recaptured CCA – The taxable difference between the adjusted cost of disposal and the UCC when the UCC is smaller. Ch. 2 Financial Statements and Long-term Financial Planning Taxes---Capital Cost Allowance (CCA)--- Closing an Asset Class Staple Supply Ltd. has just purchased a new computerized information system with a installed cost of $160,000. The compute qualifies for a CCA rate of 45%. What are the yearly CCAs? Ch. 2 Financial Statements and Long-term Financial Planning Taxes---Capital Cost Allowance (CCA)--- Closing an Asset Class CCA for Computer System Year Beginning CCA Ending UCC UCC 1 $80,000 $36,000 $44,000 ($160,000*5 ($80,000*45 ($80,000- 0%) %) 36,000) 2 124,000 55,800 68,200 (44,000+80, (124,000*45 ($124,000- 000) %) 55,800) 3 68,200 30,690 37,510 4 37,510 16,880 20,630 Ch. 2 Financial Statements and Long-term Financial Planning Taxes---Capital Cost Allowance (CCA)--- Closing an Asset Class Based on our historical experience, we think that the system will be worth only $10,000 when we get rid of it in four years. What will the tax consequences of the sale if the company has several other computers still in use in four years? Ch. 2 Financial Statements and Long-term Financial Planning Taxes---Capital Cost Allowance (CCA)--- Closing an Asset Class Based on our historical experience, we think that the system will be worth only $10,000 when we get rid of it in four years. What will the tax consequences of the sale if the company has several other computers still in use in four years? The remaining balance for that specialized computer is $20,630. If we sell it for $10,000, the computer as a class of asset reduced by $10,000. There are no tax consequences when the asset class is active. Ch. 2 Financial Statements and Long-term Financial Planning Taxes---Capital Cost Allowance (CCA)--- Closing an Asset Class Now suppose that Staple Supply will sell all its assets and wind up the company in four years. Ch. 2 Financial Statements and Long-term Financial Planning Taxes---Capital Cost Allowance (CCA)--- Closing an Asset Class Now suppose that Staple Supply will sell all its assets and wind up the company in four years. We would have been closing the asset class and claiming a terminal loss of $20,630-10,000=$10,630. Ch. 2 Financial Statements and Long-term Financial Planning Taxes---Capital Cost Allowance (CCA)--- Closing an Asset Class Kool Drinks Corporation purchased $300,000 worth of bottling machinery in 2013. Machinery falls under asset class 43 with a CCA rate of 30%. In 2015, Kool Drinks sold their machinery for $150,000 and moved their production to Mexico. Was there a capital gain, a CCA recapture or a terminal loss? What if the machinery was sold for $120,000? Ch. 2 Financial Statements and Long-term Financial Planning Taxes---Capital Cost Allowance (CCA)--- Closing an Asset Class Year Beginning UCC CCA Ending UCC 2013 150,000 45,000 105,000 2014 255,000 76,500 178,500 2015 178,500 53,550 124,950 Ch. 2 Financial Statements and Long-term Financial Planning Taxes---Capital Cost Allowance (CCA)--- Closing an Asset Class There is no capital gain because the machinery was sold for less than its original cost of $300,000. At $150,000, there is a CCA recapture of $25,050 At $120,000 there is a terminal loss of $4,950 Ch. 2 Financial Statements and Long-term Financial Planning Taxes---Capital Cost Allowance (CCA)--- Closing an Asset Class Suppose we sell the van in the second year for $10,000. Do I have a terminal loss or recaptured CCA? What does this apply for taxes given the tax rate is 40%? UCC Market value 17,850 10,000 Ch. 2 Financial Statements and Long-term Financial Planning Taxes---Capital Cost Allowance (CCA)--- Closing an Asset Class Suppose we sell the van in the second year for $10,000. Do I have a terminal loss or recaptured CCA? What does this apply for taxes given the tax rate is 40%? UCC Market value Terminal Tax saving loss 17,850 10,000 7850 3140 (17,850- 10,000)*0.40 Ch. 2 Financial Statements and Long-term Financial Planning Taxes---Capital Cost Allowance (CCA)--- Closing an Asset Class Suppose we sell the van after five years for $7,500. Do I have a terminal loss or recaptured CCA? What does this apply for taxes given the tax rate is 40%? UCC Market value 6123 7500 Ch. 2 Financial Statements and Long-term Financial Planning Taxes---Capital Cost Allowance (CCA)--- Closing an Asset Class Suppose we sell the van after five years for $7,500. Do I have a terminal loss or recaptured CCA? What does this apply for taxes given the tax rate is 40%? UCC Market value Recapture Tax pay back depreciation 6123 7500 -1377 -551