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Read from your textbook: Corporate Finance Online, Chapter 8: ?Stock Valuation and Market Efficiency? The Chapter 8 readings begin with a discussion of stocks and equity markets. Basic definitions and terminology used to describe stock and equity market transactions are presented in LO1. You will read about the types of stocks, your entitlements as a stockholder, the means to value stocks, and equity trading markets. Your readings will explain the fundamental concepts of EMH.

Discussion Topic: Stocks: 150 -200 words There are two primary means to earn income as a stockholder. The first method is dividend income and the second method is earnings from capital gains. With respect to the investor seeking dividend income, when the investor buys a stock from a corporation with a primary focus to earn dividend income they will typically expect a higher dividend on common stock versus preferred stock. Discuss the dividend payment requirements of a common stock versus preferred stock, in terms of which type of stock has a primary claim on dividend distributions. Explain why the common stock investor demands a higher dividend rate.

PRINTED BY: irisgarcia3@student.kaplan.edu. Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. Chapter 10 Capital Budgeting: Estimating Cash Flows LEARNING OBJECTIVES LO1 Calculate Depreciation and Taxes LO2 Calculate Cash Flows for an Expansion Project LO3 Calculate Cash Flows for a Replacement Project LO4 Learn Some Refinements to Capital Budgeting Introduction The Channel Tunnel (Chunnel) is a 31milelong undersea tunnel linking Great Britain and France. In 1985, the Channel Tunnel Group estimated that the cost of construction for the tunnel would be 2.6B pounds sterling. The project was plagued by cost overruns, and construction was halted several times while additional funds were raised. By the time the tunnel was completed in 1994, the total cost was 4.65B pounds sterlingan 80% cost overrun. The Chunnel was completed because of government backing. Private sector companies do not have government support. Capital budgeting errors of the magnitude experienced by the Chunnel would cause most private sector firms to fail. This chapter shows how project cash flows are calculated. We start by reviewing depreciation and taxes, since depreciation is tax deductible. Then we show how to calculate project cash flows for expansion projects and replacement projects. These are the cash flows used in the capital budgeting techniques presented in the chapter Capital Budgeting: Introduction and Techniques. At the end of this chapter, we discuss some subtleties associated with calculating incremental cash flows, we investigate how to evaluate projects with unequal lives, and we describe sensitivity analysis. The Incremental Approach In this chapter, we calculate the incremental cash flows from the project, and we compute the net present values (NPV) of the incremental cash flows. Suppose you add a new production line to a factory. You do not have to value the whole company twice: before and then after the addition. Instead, you compute the cash flows (costs and revenues) that change because of the new production line. The analysis is substantially simplified by considering only incremental cash flows. If those incremental cash flows have a positive NPV, then we know the value of the company is greater if it adopts the project and the change in the company's value is equal to the NPV of the incremental cash flows. The Explain It video provides a deeper explanation of the incremental approach. LO1 Depreciation and Taxes In this section, we review the depreciation system used by the Internal Revenue Service (IRS). Then, we define the depreciation tax shield. Finally, we show the tax impact from selling an asset. All of these are used in our calculation of project cash flows. 1.1 MACRS Depreciation The IRS's system for calculating depreciation expenses for tax purposes is called the Modified Accelerated Cost Recovery System (MACRS). It involves many \"elections\" (choices) a company is entitled to make. The interested reader is referred to the IRS website. In this chapter, we assume the General Depreciation System (GDS), using the halfyear convention and the 200% declining balance method. Within the GDS system, assets are allocated to \"property classes.\" Each property class has a different recovery period. The recovery period is the time over which the asset is depreciated to zero. Table 10.1 gives some examples of various property classes. Table 10.1 MACRS Asset Classes Type of Asset Life Manufacturing tools 3year Cars, light trucks, computers 5year Industrial equipment, offfice furniture 7year Heavyduty types of equipment 10year Residential rental property 27.5year Nonresidential real property 39year Each asset class has a set of annual depreciation rates for each year of an asset's life (see the Explain It for a table of those rates). The annual depreciation expense for an asset is simply the product of these rates and the basis of the asset. The basis is the original cost of the asset plus any other costs associated with installing the asset (which we denote C0). Example 10.1 MACRS Depreciation Expense Using the MACRS Percentage Table, calculate the depreciation expense in the first and second years for $300,000 of office furniture in class 7. SOLUTION Class 7 property has a recovery period of 7 years. The original cost of the asset is C0 = $300,000. Write your answers here. Year Depreciation Rate Depreciation Expense 1 0.1429 $300,000 0.1429 = $42,870 2 0.2449 $300,000 0.2449 = $73,470 The book value (adjusted basis) of an asset is the undepreciated or leftover value of the asset. The book value at date t, B, is equal to Bt = C0 ADeprt Eq. 10.1 where C0 = the original cost of the asset (basis) ADeprt = accumulated depreciation at date t Example 10.2 Book Value Determine the book value after 2 years for $300,000 of office furniture in class 7? SOLUTION Class 7 property has a recovery period of 7 years. The original cost of the asset is C0 = $300,000. Write your answers here. Year 1 Depreciation Rate 0.1429 Depreciation Expense $300,000 0.1429 = $42,870 2 0.2449 $300,000 0.2449 = $73,470 Accumulated Depreciation = $116,340 The book value at the end of the second year is Bt = C0 ADeprt Bt = $300,000 $116,340 = $183,660 Write your answers here. It's Time to Do a SelfTest 1. The Vogons are evaluating a new planet demolition machine that costs $25 million. The machine falls in a 7 year property class. What is the MACRS annual depreciation expense in the first year, and what is the book value at the end of the first year? Algebraic Answer Excel Answer Calculator Answer 1.2 Depreciation Tax Shield Depreciation creates a tax shield the same way as interest. Since the depreciation expense is tax deductible, it reduces taxes by an amount equal to the product of the expense and the corporate tax rate. Taxes are lower in a world with depreciation deductibility compared to a world in which depreciation is not deductible. Look at Table 10.2. The first column shows the taxes, net income, and operating cash flow in a world in which depreciation is not deductible. The second column shows an example for the same firm with $10 of depreciation. The cash flow in the nodeductibility world is $60 versus $64 in the world with deductibility. Cash flows are higher in the deductibility world, because taxes are $4 lower. The difference is called the depreciation tax shield. Table 10.2 Operating Cash Flows with and without Depreciation Deductibility No Depreciation Deductibility $10 Depreciation Expense EBIT $100 EBIT $100 Depr 0 Depr $ 10 EBT $100 EBT $ 90 Tax (40%) $ 40 Tax (40%) $ 36 Net income $ 60 Net income $ 54 + Depr $ 10 Op Cash Flow $ 60 Op Cash Flow $ 64 The cash flows calculated in the righthand column of Table 10.2 (with the depreciation deductibility) can be expressed algebraically as follows: Eq. 10.2 where The first term on the righthand side of the second line [EBIT (1 T)] is just operating cash flow in a world without depreciation deductibility. The second term (T Depr) is the depreciation tax shield. For example, if the depreciation expense is $10 and the tax rate is 40%, the depreciation tax shield is $4[0.4 $10 = $4]. Write your answers here. It's Time to Do a SelfTest 2. The table shows the income statement for Ford Motor Company in 2010. What was Ford's depreciation tax shield in 2010? Algebraic Answer Excel Answer Calculator Answer Income Statement for 2010 Ford Motor Company (millions of USD)Ford Motor Company (millions of USD) Revenues 128,954 EBITDA 7,641 Depr 492 EBIT 7,149 Interest 0 EBT 7,149 Taxes 592 Net Income 6,557 Source: Data from http://finance.yahoo.com 1.3 Tax Impact of Salvage When an asset is sold, the proceeds from the sale are a positive cash flow. The sale price of an asset is called the salvage value of the asset (denoted S). The proceeds from selling an asset are not taxable. The corporate tax system taxes income from the ongoing business of the company. If an asset is sold for more than its purchase price, then the difference is a taxable capital gain. This situation is rare, and we do not consider it further. When an asset is sold for less than its purchase price, there is a tax adjustment at the end of the year that depends on the relative sizes of the salvage value and the book value. Recaptured Depreciation The situation in which the salvage value exceeds the book value is called recaptured depreciation. The salvage value exceeds the book value when the asset did not depreciate (economically) as much as the MACRS system allowed. As a result, the company has had too many depreciation tax shields, and it must pay extra tax to compensate. In a sense, the government is recapturing the excessive depreciation expenses it offered the business. In a recaptured depreciation situation, the company adds the difference between the salvage value and the book value (S B) to its taxable income in the year in which the asset is sold. The additional taxes resulting from the sale are given by Tax on sale = T (S B) Eq. 10.3 This is a positive number (since S > B), and so it reduces cash flows in the terminal year of the project. We define net salvage as Net salvage = S Tax on sale Eq. 10.4 Net salvage is simply equal to the proceeds received from selling the asset minus the taxes paid on the sale of the asset. Ordinary Loss Ordinary loss is the situation in which the salvage value is less than the book value of the asset. In this case, the asset has depreciated (economically) by more than the MACRS system allowed. The company has not had sufficient depreciation expenses, and it has paid too much tax. The company can deduct the difference from taxable income, which reduces taxes owing and so acts as a tax rebate. The amount of the tax rebate is Tax on sale = T (S B) This is a negative number (since S