Implementing the NPV Rule Lecture 9 PDF

Implementing the NPV Rule Lecture 9 1 1.Introduction: calculating NPV 1.calculate the taxable operating profits attributable to the project, and hence calculate the corporation taxes associated with the project. 2.calculate the before-tax incremental operating cash flows from the project, deduct tax...

Implementing the NPV Rule Lecture 9 1 1.Introduction: calculating NPV 1.calculate the taxable operating profits attributable to the project, and hence calculate the corporation taxes associated with the project. 2.calculate the before-tax incremental operating cash flows from the project, deduct taxes, and include net capital spending to give the corresponding after-tax free cash flows. 3.calculate the NPV of the project using discounted cash flow (DCF): discount the after-tax cash flows at the project’s required rate of return 2 2. Implementing DCF 1. We need to be able to convert accounting profits into cash flows…. (a) raw data comes from accounting information systems (b) tax is based on profits 2. We discount cash flows cash flows  accounting profits (a) depreciation not a cash flow; cash flow occurs when the asset is purchased the firm deducts capital allowances in calculating taxable profits (b) working capital (WC) accounting sales/costs  cash flows; changes in working capital reflect the differences WC also reflects changes in investment in stocks or cash add decreases in WC to profits to get cash flows 3 A word on: Depreciation/Capital Allowance Depreciation-Allocation cost of investment over a number of periods Non cash expenses Capital allowance- governed by tax law Straight line; Cost; £100,000, Life; 5 years➔ £100,000/5= £20,000 per year Reducingbalance; accelerated write-down Depreciation 1 2 3 4 Initial investment 1,000,000 750,000 562,500 421,875 25% 250,000 187,500 140,625 105,469 Value year end 750,000 562,500 421,875 4 316,406 Example: Calculating after-tax cash flows Assume for a particular year, Sales Operating exps (excl depreciation) Accounting depreciation Capital allowance Change in working capital Corporation tax rate 500,000 280,000 50,000 42,000 -10,000 33% Taxable profits = (500000 – 280000 – 42000) = 178,000  tax = 0.33 x 178000 = 58,740  after-tax cash flows Sales less expenses Add decrease in working capital Less taxes After-tax cash flow 220,000 10,000 58,740 £171,260 5 3. we calculate cash flows after corporation tax  use after-tax discount rate 4. taxable profits and cash flows must be incremental--- difference between figures when the project is accepted and when it is rejected. Losses/profits/revenues/costs already made are irrelevant (sunk) Project interdependencies (side-effects) Relevant costs are opportunity costs Arbitrarily allocated costs are irrelevant 5. financing costs excluded from cash flows 6. discount nominal CFs at a nominal discount rate 6 7. after-corporate-tax discount rate = project’s weighted average cost of capital (WACC), r* = re E/V + rd(1 – Tc) D/V, re = the cost of equity capital for the project (the return shareholders require given the riskiness of the project cash flows and the financing structure for the project); rd = the cost of debt capital for the project (the return debt holders require given the riskiness of their repayment stream); Tc= the project’s expected, effective rate of corporation tax (often assumed to be the statutory rate of corporation tax); E/V= the proportion of the present value of the project financed by equity; D/V= the proportion of the present value of the project financed by debt; 7 Assume re = 0.28, rd = 0.12, Tc = 0.33, E/V = 0.6, D/V = 0.4 r* = 0.28(0.6) + 0.12(1 – 0.33) (0.4)  0.2 (20%) 8 Summary 1. Calculate NPV by (I) finding the extra tax paid by taking on the project, (ii) calculating after-tax free cash flows, and (iii) discount at the required rate of return 2. taxes and cash flows must be incremental 3. the required rate of return is a weighted average of all after-tax costs of finance 4. with real investment options, NPV must include the effects of options gained or lost 9