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FURTHER NOTES AND WRINKLES ARISING FROM BLOOPER PROJECT

Before we leave Blooper and its magnoosium project, we should cover a few extra wrinkles.

A Further Note on Depreciation. We warned you earlier not to assume that all cash flows are likely to increase with inflation. The depreciation tax shield is a case in point, because the Internal Revenue Service lets companies depreciate only the amount of the original investment. For example, if you go back to the IRS to explain that inflation mushroomed since you made the investment and you should be allowed to depreciate more, the IRS won t listen. The nominal amount of depreciation is fixed, and therefore the higher the rate of inflation, the lower the real value of the depreciation that you can claim.

We assumed in our calculations that Blooper could depreciate its investment in mining equipment by $2 million a year. That produced an annual tax shield of $2 million АГАз .35 = $.70 million per year for 5 years. These tax shields increase cash flows from operations and therefore increase present value. So if Blooper could get those tax shields sooner, they would be worth more, right? Fortunately for corporations, tax law allows them to do just that. It allows accelerated depreciation.

The rate at which firms are permitted to depreciate equipment is known as the Modified Accelerated Cost Recovery System, or MACRS. MACRS places assets into one of six classes, each of which has an assumed life. Table 4.6 shows the rate of depreciation that the company can use for each of these classes. Most industrial equipment falls into the 5- and 7-year classes. To keep life simple, we will assume that all of Blooper s mining equipment goes into 5-year assets. Thus Blooper can depreciate 20 percent of its $10 million investment in Year 1. In the second year it could deduct depreciation of .32 АГАз 10 = $3.2 million, and so on.6

How does use of MACRS depreciation affect the value of the depreciation tax shield for the magnoosium project? Table 4.7 gives the answer. Notice that it does not affect the total amount of depreciation that is claimed. This remains at $10 million just as before. But MACRS allows companies to get the depreciation deduction earlier, which increases the present value of the depreciation tax shield from $2,523,000 to $2,583,000, an increase of $60,000. Before we recognized MACRS depreciation, we calculated project NPV as $3,564,000. When we recognize MACRS, we should increase that figure by $60,000.

All large corporations keep two sets of books, one for stockholders and one for the Internal Revenue Service. It is common to use straight-line depreciation on the stockholder books and MACRS depreciation on the tax books. Only the tax books are relevant in capital budgeting.

What to Do about Salvage Value. We assumed earlier that the mining equipment would be worthless when the magnoosium mine closed. But suppose that it can be sold for $2 million in Year 6. (The $2 million forecast salvage value recognizes inflation.) You recorded the initial $10 million investment as a negative cash flow. Now in Year 6 you have a forecast return of $2 million of that investment. That is a positive cash flow.

When you sell the equipment, the IRS will check its books and see that you have already claimed depreciation of $10 million.7 So the value of your investment in Blooper s tax books will be zero. Any difference between the sale price ($2 million) and the value in the tax books (zero) is treated as a taxable gain. So your sale of the equipment will also land you with an additional tax bill in Year 6 of .35 АГАз ($2 million 0) = $.70 million. The extra cash flow in Year 6 is Salvage value tax on gain = $2 million $.70 million = $1.30 million

When discounted back to Year 0, this adds $.659 million, or $659,000, to the value of the project.

Summary

How should the cash flows properly attributable to a proposed new project be calculated?

Here is a checklist to bear in mind when forecasting a project s cash flows:

Discount cash flows, not profits.

Estimate the project s incremental cash flows that is, the difference between the cash flows with the project and those without the project.

Include all indirect effects of the project, such as its impact on the sales of the firm s other products.

Forget sunk costs.

Include opportunity costs, such as the value of land which you could otherwise sell.

Beware of allocated overhead charges for heat, light, and so on. These may not reflect the incremental effects of the project on these costs.

Remember the investment in working capital. As sales increase, the firm may need to make additional investments in working capital and, as the project finally comes to an end, it will recover these investments.

Do not include debt interest or the cost of repaying a loan. When calculating NPV, assume that the project is financed entirely by the shareholders and that they receive all the cash flows. This isolates the investment decision from the financing decision.

How can the cash flows of a project be computed from standard financial statements?

Project cash flow does not equal profit. You must allow for changes in working capital as well as noncash expenses such as depreciation. Also, if you use a nominal cost of capital, consistency requires that you forecast nominal cash flows that is, cash flows that recognize the effect of inflation.

How is the company s tax bill affected by depreciation and how does this affect project value?

Depreciation is not a cash flow. However, because depreciation reduces taxable income, it reduces taxes. This tax reduction is called the depreciation tax shield. Modified Accelerated Cost Recovery System (MACRS) depreciation schedules allow more of the depreciation allowance to be taken in early years than under straight-line depreciation. This increases the present value of the tax shield.

How do changes in working capital affect project cash flows?

Increases in net working capital such as accounts receivable or inventory are investments, and therefore use cash that is, they reduce the net cash flow provided by the project in that period. When working capital is run down, cash is freed up, so cash flow increases.

7 The MACRS tax depreciation schedules assume zero salvage value at the end of assets depreciable lives. For reports to shareholders, however, positive expected salvage values are often recognized. For example, Blooper s financial statements might assume that its $10 million investment in mining equipment would be worth $2 million in Year 6. In this case, the depreciation reported to shareholders would be based on the difference between investment and salvage value, that is, $8 million. Straight-line depreciation would be $1.6 million per year.

5 Financial managers sometimes assume cash flows arrive in the middle of the calendar year, that is, at the end of June. This makes NPV also a midyear number. If you are standing at the start of the year, the NPV must be discounted for a further half-year. To do this, divide the midyear NPV by the square root of (1 + r).

This midyear convention is roughly equivalent to assuming cash flows are distributed evenly throughout the year. This is a bad assumption for some industries. In retailing, for example, most of the cash flow comes late in the year, as the holiday season approaches.

6 You might wonder why the 5-year asset class provides a depreciation deduction in Years 1 through 6. This is because the tax authorities assume that the assets are in service for only 6 months of the first year and 6 months of the last year. The total project life is 5 years, but that 5-year life spans parts of 6 calendar years. This assumption also explains why the depreciation is lower in the first year than it is in the second.

MODIFIED ACCELERATED COST RECOVERY SYSTEM (MACRS) Depreciation method that allows higher tax deductions in early years and lower deductions later.