Asset Disposition At the end of the useful life of an asset, the firm may be able to sell it or
Asset Disposition At the end of the useful life of an asset, the firm may be able to sell it or
may have to pay someone to haul it away. If the firm is making a deci- sion that involves replacing an existing asset, the cash flow from dispos- ing of the old asset must be figured in since it is a cash flow relevant to the acquisition of the new asset.
If the firm disposes of an asset, whether at the end of its useful life or when it is replaced, two types of cash flows must be considered:
1. what you receive or pay in disposing of the asset; and
2. any tax consequences resulting from the disposal. Cash flow from disposing assets
= Proceeds or payment from disposing assets
– Taxes from disposing assets The proceeds are what you expect to sell the asset for if you can get
someone to buy it. If the firm must pay for the disposal of the asset, this cost is a cash outflow.
Consider the investment in a gas station. The current owner wants to sell the station to another gas station proprietor. But if a buyer cannot be found and the station abandoned, the current owner may be required to remove the underground gasoline storage tanks to prevent environmen- tal damage. Thus, a cost is incurred at the end of the asset’s life.
The tax consequences are a bit more complicated. Taxes depend on: (1) the expected sales price, (2) the book value of the asset for tax pur- poses at the time of disposition, and (3) the tax rate at the time of disposal.
If a firm sells the asset for more than its book value but less than its original cost, the difference between the sales price and the book value for tax purposes (called the tax basis) is a gain, taxable at ordinary tax rates. If a firm sells the asset for more than its original cost, then the gain is broken into two parts:
1. Capital gain: the difference between the sales price and the original cost; and
2. Recapture of depreciation: the difference between the original cost and the tax basis.
Capital Budgeting: Cash Flows
The capital gain is the benefit from the appreciation in the value of the asset and may be taxed at special rates, depending on the tax law at the time of sale. The recapture of depreciation represents the amount by which the firm has overdepreciated the asset during its life. This means that more depreciation has been deducted from income (reducing taxes) than necessary to reflect the usage of the asset. The recapture portion is taxed at the ordinary tax rates, since the excess depreciation taken all these years has reduced taxable income.
If a firm sells an asset for less than its book value, the result is a cap- ital loss. In this case, the asset’s value has decreased by more than the amount taken for depreciation for tax purposes. A capital loss is given special tax treatment:
■ If there are capital gains in the same tax year as the capital loss, they are combined, so that the capital loss reduces the taxes paid on capital gains, and
■ If there are no capital gains to offset against the capital loss, the capital loss is used to reduce ordinary taxable income.
The benefit from a loss on the sale of an asset is the amount by which taxes are reduced. The reduction in taxable income is referred to as a tax shield, since the loss shields some income from taxation. If the firm has a loss of $1,000 on the sale of an asset and has a tax rate of 40%, this means that its taxable income is $1,000 less and its taxes are $400 less than they would have been without the sale of the asset.
Suppose you are evaluating an asset that costs $10,000 that you expect to sell in five years. Suppose further that the tax basis of the asset for tax purposes will be $3,000 after five years and that the firm’s tax rate is 40%. What are the expected cash flows from disposing this asset?
If the firm expects to sell the asset for $8,000 in five years, $10,000 − $3,000 = $7,000 of the asset’s cost will be depreciated; yet the asset lost only $10,000 − $8,000 = $2,000 in value. Therefore, the firm has over- depreciated the asset by $5,000. Because this overdepreciation represents deductions to be taken on the firm’s tax returns over the five years that don’t reflect the actual depreciation in value (the asset doesn’t lose $7,000 in value, only $2,000), this $5,000 is taxed at ordinary tax rates. If the firm’s tax rate is 40%, the tax will be 40% × $5,000 = $2,000.
The cash flow from disposition is the sum of the direct cash flow (someone pays us for the asset or the firm pays someone to dispose of it) and the tax consequences. In this example, the cash flow is the $8,000 we expect someone to pay the firm for the asset, less the $2,000 in taxes we expect the firm to pay, or $6,000 cash inflow.
LONG-TERM INVESTMENT DECISIONS
Suppose instead that the firm expects to sell this asset in five years for $12,000. Again, the asset is overdepreciated by $7,000. In fact, the asset is not expected to depreciate, but rather appreciate over the five years. The $7,000 in depreciation is recaptured after five years and taxed at ordinary rates: 40% of $7,000, or $2,800. The $2,000 capital gain is the appreciation in the value of the asset and may be taxed at special rates. If the tax rate on capital gain income is 30%, you expect the firm to pay 30% of $2,000, or $600 in taxes on this gain. Selling the asset in five years for $12,000 therefore results in an expected cash inflow of $12,000 − $2,800 − $600 = $8,600.
Suppose the firm expects to sell the asset in five years for $1,000. If the firm can reduce its ordinary taxable income by the amount of the capital loss, $3,000 − $1,000 = $2,000, its tax bill will be 40% of $2,000, or $800 because of this loss. We refer to this reduction in the taxes as a tax shield, since the loss “shields” $2,000 of income from taxes. Combining the $800 tax reduction with the cash flow from sell- ing the asset, the $1,000, gives the firm a cash inflow of $1,800. 4
The calculation of the cash flow from disposition for the alternative sales prices of $8,000, $12,000, and $1,000 are shown in Exhibit 12.1.
EXHIBIT 12.1 Expected Cash Flows from the Disposition of an Asset The firm pays $10,000 for an asset and expects to dispose of it in five years, when the asset has a book value of $3,000. The firm’s ordinary tax rate is 40% and the tax rate on capital gains is 30%.
Original cost > Expected sales price > Tax Basis
Tax on disposition: Sales price
Tax basis
Ordinary tax rate
Tax on recapture
Cash flows: Proceeds from disposition
Less tax on gain
Cash flow on disposition
4 On the other hand, if the firm expects other capital gains five years from now, the amount of the tax shield would be less since this loss would be used to first offset any
capital gains taxed at 30%. In this case, the expected tax shield is only 30% of $2,000, or $600 because we must first use the capital loss to reduce any capital gains.
Capital Budgeting: Cash Flows
EXHIBIT 12.1
(Continued) Expected sales price > Original cost > Tax basis
Tax on disposition: Sales price
Original cost
Capital gain
Capital gains tax rate
Tax on capital gain
Original cost
Tax basis
Gain (recapture)
Ordinary tax rate
Tax on recapture
Cash flows: Proceeds from disposition
Less tax on capital gain
Less tax on recapture
Cash flow on disposition
Tax basis > Expected sales price
Tax shield on disposition: Book value
Tax basis
Ordinary tax rate
Tax shield on loss
Cash flows: Proceeds from disposition
Plus tax shield on loss
Cash flow on disposition
Let’s also not forget about disposing of any existing assets. Suppose the firm bought equipment ten years ago and at that time expected to be able to sell it 15 years later for $10,000. If the firm decides today to replace this equipment, it must consider what it is giving up by not dis-
LONG-TERM INVESTMENT DECISIONS
posing of an asset as planned. If the firm does not replace the equipment today, it would continue to depreciate it for five more years and then sell it for $10,000; if the firm replaces the equipment today, it would not have five more years’ depreciation on the replaced equipment and it would not have $10,000 in five years (but perhaps some other amount today). This $10,000 in five years, less any taxes, is a foregone cash flow that we must figure into the investment cash flows. Also, the deprecia- tion the firm would have had on the replaced asset must be considered in analyzing the replacement asset’s operating cash flows.
Parts
» Financial Management and Analysis
» SECURITIES MARKETS The primary function of a securities market—whether or not it has a
» Stock Exchanges Stock exchanges are formal organizations, approved and regulated by
» Stock Market Indicators Stock market indicators have come to perform a variety of functions,
» Efficient Markets Investors do not like risk and they must be compensated for taking on
» THE FEDERAL RESERVE SYSTEM The United States has a central monetary authority known as the Fed-
» The Fed and the Money Supply Financial managers and investors are interested in the supply and
» Deposit Institutions Traditionally, the United States has had several types of deposit institu-
» Investment Banking The primary market involves the distribution to investors of newly
» Interest Rates and Yields Because bonds are traded in the secondary market, the price of the bond
» The Risk Premium Market participants talk of interest rates on non-Treasury securities as
» OPTIONS An option is a contract in which the writer of the option grants the
» Buying Call Options The purchase of a call option creates a position referred to as a long call
» Buying Put Options The buying of a put option creates a financial position referred to as a
» CAP AND FLOOR AGREEMENTS There are agreements available in the financial market whereby one
» I n assessing a company’s current and future cash flows, the financial
» Depreciation for Tax Purposes For accounting purposes, a firm can select a method of depreciation
» Capital Gains We tend to use the term “capital gain” loosely to mean an increase in the
» Current assets (also referred to as circulating capital and working
» Noncurrent Assets Noncurrent assets are assets that are not current assets; that is, it is not
» Deferred Taxes Along with long-term liabilities, the analyst may encounter another
» THE INCOME STATEMENT An income statement is a summary of the revenues and expenses of a
» THE STATEMENT OF CASH FLOWS The statement of cash flows is a summary over a period of time of a
» T he notion that money has a time value is one of the most basic con-
» DETERMINING THE PRESENT VALUE Now that we understand how to compute future values, let’s work the
» Shortcuts: Annuities There are valuation problems that require us to evaluate a series of level
» THE CALCULATION OF INTEREST RATES
» T here are a number of factors that affect a stock’s price and its value to
» Dividend Valuation Model If dividends are constant forever, the value of a share of stock is the
» Returns on Common Stock As we saw in the preceding section, the value of a stock is the present
» Straight Coupon Bond Suppose you are considering investing in a straight coupon bond that:
» Returns on Bonds If you invest in a bond, you realize a return from the interest it pays (if
» Coupon Bonds The present value of a bond is its current market price, which is the dis-
» Callable Bonds Some bonds have a feature, referred to as a call feature, that allows the
» RISK Whenever you make a financing or investment decision, there is some
» Financial Risk When we refer to the cash flow risk of a security, we expand our con-
» Reinvestment Rate Risk Another type of risk is the uncertainty associated with reinvesting cash
» Interest Rate Risk Interest rate risk is the sensitivity of the change in an asset’s value to
» Currency Risk In assessing the attractiveness of an investment, we estimated future cash
» 5 (Continued) Portfolio of Investment C and Investment D
» Portfolio Size and Risk What we have seen for a portfolio with two assets can be extended to
» I n Chapters 8 through 10, we discussed and practiced techniques for
» The Cost of Debt Because Congress allows you to deduct from your taxable income the
» The Cost of Common Stock The cost of common stock is the cost of raising one more dollar of com-
» INTEGRATIVE EXAMPLE: ESTIMATING THE COST OF CAPITAL FOR DUPONT
» CAPITAL BUDGETING Because a firm must continually evaluate possible investments, capital
» Investment Cash Flows When we consider the cash flows of an investment we must also consider
» Asset Disposition At the end of the useful life of an asset, the firm may be able to sell it or
» Change in Expenses When a firm takes on a new project, the costs associated with it will
» Putting It All Together Here’s what we need to put together to calculate the change in the firm’s
» The Analysis To determine the relevant cash flows to evaluate this expansion, let’s
» The Problem The new equipment costs $300,000 and is expected to have a useful life of
» T he value of a firm today is the present value of all its future cash
» Payback Period The payback period for a project is the length of time it takes to get your
» Discounted Payback Period The discounted payback period is the time needed to pay back the origi-
» Net Present Value If offered an investment that costs $5,000 today and promises to pay
» Net Present Value Decision Rule
» Profitability Index The profitability index (PI) is the ratio of the present value of change in
» Stand-Alone versus Market Risk If we have some idea of the uncertainty associated with a project’s
» Sensitivity Analysis Estimates of cash flows are based on assumptions about the economy,
» Simulation Analysis Sensitivity analysis becomes unmanageable if we change several factors
» Options on Real Assets The valuation of stock options is rather complex, but with the assis-
» OVERVIEW OF DEBT OBLIGATIONS In a debt obligation, the borrower receives money in exchange for a
» Repayment Schedule Term loans are usually repaid in installments either monthly, quarterly,
» Interest In the United States, interest is typically paid twice a year at six month
» Debt Retirement By the maturity date of the bond, the issuer must pay off the entire par
» Rating Systems In all systems the term high grade means low default risk, or conversely,
» S uppose you buy a new car that costs $20,000 and you pay cash for it.
» Limited Liability The corporate form of doing business is attractive to owners of a busi-
» Stock Ownership We can classify a corporation according to whether its shares of stock
» Voting Rights Common shareholders are generally granted rights to
» Corporate Democracy Corporate democracy gives owners of the corporation a say in how to
» Methods of Repurchasing Stock
» Dividends Although a firm’s board of directors declares a dividend on its preferred
» Sinking Funds Because there is no legal obligation to pay the preferred dividend and
» DEBT VERSUS EQUITY The combination of debt and equity used to finance a firm’s projects is
» CAPITAL STRUCTURE AND TAXES We’ve seen how the use of debt financing increases the risk to owners;
» Interest Tax Shield An interesting element introduced into the capital structure decision is
» Unused Tax Shields The value of a tax shield depends on whether the firm can use an interest
» PUTTING IT ALL TOGETHER As a firm increases the relative use of debt in the capital structure, its
» A s we saw in Part Three, managers base decisions about investing in
» CASH MANAGEMENT Cash flows out of a firm as it pays for the goods and services it pur-
» The Baumol Model The Baumol Model is based on the Economic Order Quantity (EOQ)
» The Miller-Orr Model The Baumol Model assumes that cash is used uniformly throughout the
» The Check Clearing Process The process of receiving cash from customers involves several time-
» RECEIVABLES MANAGEMENT When a firm allows customers to pay for goods and services at a later
» Captive Finance Subsidiaries Some firms choose to form a wholly-owned subsidiary—a corporation
» The Economic Order Quantity Model The Economic Order Quantity (EOQ) model helps us determine what
» Just-in-Time Inventory The goal of the just-in-time (JIT) inventory model is to cut down on the
» Monitoring Inventory Management We can monitor inventory by looking at financial ratios in much the
» Add-on-interest Another way of stating interest is with add-on interest, where the total
» Trade Credit Trade credit is granted by a supplier to a customer purchasing goods or
» Commercial Paper Commercial paper is an unsecured promissory note with a fixed matu-
» Types of Inventory Financing There are several different types of loan arrangements that involve
» SPECIALIZED COLLATERALIZED BORROWING ARRANGEMENT FOR FINANCIAL INSTITUTIONS
» RATIOS AND THEIR CLASSIFICATION
» RETURN-ON-INVESTMENT RATIOS Return-on-investment ratios compare measures of benefits, such as earn-
» The Du Pont System The returns on investment ratios give us a “bottom line” on the perfor-
» LIQUIDITY Liquidity reflects the ability of a firm to meet its short-term obligations
» PROFITABILITY RATIOS We have seen that liquidity ratios tell us about a firm’s ability to meet its
» Using a Benchmark To interpret a firm’s financial ratios we need to compare them with the
» INTEGRATIVE EXAMPLE: FINANCIAL ANALYSIS OF WAL-MART STORES 6
» Dilutive Securities For a company having securities that are dilutive—meaning they could
» ANALYSTS’ FORECASTS There are many financial services firms offering projections on different
» PRICE-EARNINGS RATIO Many investors are interested in how the earnings are valued by the mar-
» FREE CASH FLOW Cash flows without any adjustment may be misleading because they do
» NET FREE CASH FLOW There are many variations in the calculation of cash flows that are used
» Using Cash Flow Information The analysis of cash flows provides information that can be used along
» THE GLOBAL ECONOMY Many countries export a substantial portion of the goods and services
» FOREIGN CURRENCY Doing business outside of one’s own country requires dealing with the cur-
» The Euro The European Union consists of 15 European member countries that
» Global Equity Market In 1985, Euromoney surveyed several firms that either listed stock on a
» Currency Swaps When issuing bonds in another country where the bonds are not denom-
» Currency Option Contracts In contrast to a forward or futures contract, an option gives the option
» A s an alternative to the issuance of a corporate bond, a corporation
» WHAT RATING AGENCIES LOOK AT IN RATING ASSET-BACKED SECURITIES
» Third-Party Guarantees Perhaps the easiest form of credit enhancement to understand is insur-
» EXAMPLE OF AN ACTUAL STRUCTURED FINANCE TRANSACTION
» Accounting for Capital Leases
» FEDERAL INCOME TAX REQUIREMENTS FOR TRUE LEASE TRANSACTIONS
» Direct Cash Flow from Leasing When a firm elects to lease an asset rather than borrow money to pur-
» S tructured financing is a debt obligation that is backed by the value of
» CREDIT IMPACT OBJECTIVE While the sponsor or sponsors of a project financing ideally would pre-
» A business that maximizes its owners’ wealth allocates its resources
» Budgeting In budgeting, we bring together analyses of cash flows, projected income
» Taxes and Transaction Costs The Black-Scholes option pricing model ignores taxes and transaction
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