lecture # 10 eva and disposal of assets

Lecture # 10

Economic Value Added

Disposal of Assets

1 Dr. A. Alim

EVA - Explained

In a given year a certain NPAT is achieved.

Recall: NPAT = TI – Taxes

After-tax Rate of Return is defined as:

ROR = NPAT / Invested Capital

or NPAT = ROR x Invested Capital

If ROR=MARR

NPAT (minimum) = MARR x Invested Capital

For ROR to be higher than MARR

then NPAT > MARR x Invested Capital

(MARR x Invested capital) is also called cost of invested capital

The difference between the actual NPAT (at ROR) and the minimum

NPAT (at MARR) is called the economic value added; EVA.

Slide Sets to accompany Blank & Tarquin, Engineering

Economy, 7th Edition, 2012 3 © 2012 by McGraw-Hill, New York, N.Y All Rights Reserved

EVA - Explained

EVA t = NPAT t – cost of invested capital

The annual EVA is the amount of the NPAT

remaining after removing the cost of invested

capital during the year. That is, EVA indicates the

project’s excess contribution to the net profit of

the corporation after taxes.

EVA t = NPAT t – MARR (after tax) . (BV) t-1



EVA - Explained

ROR

(EVA)t

Cost of Invested

Capital =

MARR x (BV)t-1

(NPAT)t



MARR

EVA - Explained

EVA is a useful tool to evaluate the worth of a project. It

reflects the added value achieved by realizing a ROR

higher than MARR. The bigger the delta is (ROR –

MARR), the higher the EVA is.

Usually the AW of a series of yearly EVA’s is computed.

AW > 0 is desirable, the more positive it is , the

better.

Comparing AW of EVA for two projects can be

used to decide on which project to invest in.

Similar analysis of AW of CFAT may also be

conducted.



EVA - Explained

Recall, firms often have two sets of books

relating to depreciation:

One for tax purposes and,

One for internal management use. (book

depreciation).

For EVA, book depreciation is more often used.

More closely represent the true rate of usage of the assets in

question.

Typically, the classical SL method with zero salvage value is

used.




Economy, 7th Edition, 2012

© 2012 by McGraw-Hill, New York, N.Y All Rights Reserved 8

CFAT and EVA Analysis – Example 13.11, Basics of Engineering

Economy, McGraw Hill, 2008, by Blank and Tarquin. Page 336.

After-tax MARR = 12%, SL depreciation Te = 40%

For EVA calculation each year t:

D = $500,000 / 4 = $125,000

NPATt = TI × (1 – Te) = (170,000 – 125,000)(0.6) = $27,000

EVAt = NPATt – MARR × (BVt-1) = 27,000 – 0.12(BVt-1)

Solution:



Initial investment $500,000

GI – E $170,000 per year

Estimated life 4 years

Salvage value None

Observations about EVA and CFAT analysis

EVA

There is no EVA in year t = 0, since NPAT and cost of invested

capital are present only for years 1 to n

AW of EVA < 0 means project is not justified at 12%

Project does not add value to the corporation until year 3 when EVA

turns positive

CFAT

AW of CFAT < 0 means project is not justified at 12%

CFAT estimates actual cash flow, which is negative in year 0 and

positive thereafter

CONCLUSIONS

AW values of EVA and CFAT series are exactly equal

Two methods are economically equivalent



Conclusion: EVA and CFAT

EVA values represent a project’s periodic contribution to the value of the corporation or firm.

The CFAT values represent the actual cash flows – after tax – into the corporation or firm.

Corporate executives generally prefer to view the EVA values. Studies have shown that EVA correlates better with stock price.

Popular concept in Europe

Value-added taxes are imposed in Europe on certain products

and paid to the government.

EVA analysis is a good tool to compare alternative investments.



Disposal of assets

• Firms sell or dispose of assets from time to time.

• If the asset has not been fully depreciated at the selling time, it will have a book value BVt

• Four possible situations may occur, depending on how the selling price SP relates to first cost P and to the current book value BVt

Slide Sets to accompany

Blank & Tarquin, Engineering


15 © 2012 by McGraw-Hill, New

York, N.Y All Rights Reserved

Summary for Disposal Analysis






1) Capital Gain: CG

• Occurs when the selling price exceeds the first cost • Capital Gain is defined as:

CG = Selling Price – First Cost • Certain Assets will gain value over time and could be

sold for more than what was originally paid for them. Examples are land and buildings.

• This will generate a taxable income (TI) and additional capital gain tax will have to be paid in the year of sale.

• In most cases capital gain is taxed at the same rate as ordinary income, unless a different rate is specified (in which case it is usually 28%)






2) Depreciation recapture: DR • Occurs when the selling price is higher than the

current book value.

• The term “Depreciation Recapture” applies.

• DR = SP – BVt

• This will generate a tax liability and tax will have to be paid!

• When the SP exceeds the first cost, a capital gain is also incurred. In this case the TI due to the sale is the gain plus the DR. The DR is this case is the total amount of depreciation taken so far.






3) Capital Loss: CL

• A capital loss occurs when an asset is sold for

less than it’s current book value.

• CL = BVt – SP

• Could generate a tax savings since the “loss” could be tax deductible within certain rules.






4) No gain No Loss case

This occurs when the asset is sold for a price = BVt

SP = BVt no tax liability generated



Economy, 7th Edition, 2012 20 © 2012 by McGraw-Hill, New


Disposal Example

• Assume an asset was originally purchased for

$10,000, 3 years ago.

• Assume the current book value for tax purposes is $3000.

• We will apply three different hypothetical selling prices to see the various tax implications due to disposal.

• Assume income tax rate of 34% , and capital gain tax rate of 28% apply.






Disposal: SP > BVtime of sale

• Assume SP = $4,000.

• BV = $3,000.

• Compute (SP – BV) = (4,000 – 3000).

• Equals +$1,000. (Recaptured Depr.)

• Tax Rule: Treated as ordinary income to the firm and taxed at the tax rate.

• Tax: $1000(0.34) = $340.00






Disposal: SP = BVTime of Sale

• Assume SP = $3,000.

• Compute (SP – BV) = (3000 – 3000) =0

• No gain or loss on sale;

• No tax implications!

• When asset is disposed of for it’s current book value there is no recaptured depreciation and no corresponding tax.






Disposal: SP < BVTime of Sale

• Assume SP = $2,000;

• BV = $3000

• Compute: (SP – BV) = (2000 – 3000) =

– -$1,000.

– “Minus” means “loss on disposal”

• The loss can be treated as a negative

ordinary income and may be deducted from

capital gain in another asset.

• Tax: (-1000)(0.34) = - $340.00

• This is a tax credit.






Disposal: 4th Situation: SP > B

• What if the SP is greater than the original basis

of the asset? (rare for productive assets)

• Assume SP = $12,000;

• B = $10,000.

• BVtime of sale = $3,000

• Two Components to deal with:

• 1st component : Capital gain

(SP – B) = 12,000 – 10,000 = $2,000







• 2nd Component : Depreciation recapture:

B – BVTime of Sale

$10,000 - $3,000 = $7,000

• Tax Situation for Economy Studies

– Tax the “gain” part at whatever the current

capital gain tax rate is at the time (28%) on

gains.







• Possible Tax Evaluation assuming the

“gain” part is taxed at 28% and DR at 34%

– Gain: $2000(0.28) = $560.

– DR: $7000(0.34) = $2380

– Total Tax: $2940






“0” Salvage Value Issue

• Recall, MACRS assumes a “0” salvage value for

fully depreciated assets.

• What if an asset is fully depreciated,?

• Under MACRS the book value at the time of disposal will be 0.

• IF SP > 0 then the SP amount is the DR and is taxed at the ordinary tax rate!

• IF SP > first cost, then add capital gain tax to full DR tax.






Asset disposal conclusion

We now expand the TI expression to accommodate any additional taxes resulting from the sale:

TI = GI – E – D + DR + CG – CL We also need to remember that for the year in which the asset is sold: CFBT = GI – E + SP






Authored by Don Smith, Texas A&M University 2004 Slide Sets to accompany Blank &

Tarquin, Engineering Economy,

7th Edition, 2012



Example

Solution: Depreciation recapture and capital gain are present

DR = 150,000 – 43,200 = $106,800 CG = 180,000 – 150,000 = $30,000 MACRS D3 = 0.192(150,000) = $28,800

TI = GI – E – D + DR + CG = 800,000 – 50,000 – 28,800 + 106,800 + 30,000

= $858,000

Taxes = TI × Te = 858,000 × 0.34 = $291,720

Note: If not sold now, taxes = (800,000 – 50,000 – 28,800) × (0.34) = $245,208

© 2012 by McGraw-Hill, New York, N.Y All Rights Reserved 31

A laser-based system installed for B = $150,000 three years ago can be sold for SP = $180,000 now. Based on 5-year MACRS recovery, BV3 = $43,200. GI for year is $800,000 and annual operating expenses average $50,000. Determine TI and taxes if Te = 34% and the system is sold now.

Slide Sets to accompany Blank &


7th Edition, 2012

Example: Four years ago a company purchased an asset for $200,000. MACRS depreciation Was charged over a 3-year recovery period. The following gross incomes and Expenses were recorded, and an effective tax rate of 40% was applied. The asset is now sold for $20,000. Tabulate the taxes and the CFAT for the 4 years. Year 1 2 3 4 GI, $ 80,000 150,000 120,000 100,000 E, $ 20,000 40,000 30,000 50,000






Year GI E P or SP d D BV DR TI Taxes CFAT

0 0 0 (200,000) 200,000 (200,000)

1 80,000 (20,000) 0.3333 66,660 133,340 (6,660) (2,664) 62,664

2 150,000 (40,000) 0.4445 88,900 44,440 21,100 8,440 101,560

3 120,000 (30,000) 0.1481 29,620 14,820 60,380 24,152 65,848

4 100,000 (50,000) 20,000 0.0741 14,820 0 20,000 55,180 22,072 47,928

Solution: First cost = $200,000 Selling price = $20,000 Depreciation: 3 years MACRS recovery period Book value at end of year 4 is zero Tax rate = 40%

First cost › selling price › BV. Hence, no capital gain or capital loss, but we have depreciation Recapture.

TI (year 1-3) = GI – E – D TI (year 4) = GI – E – D + DR DR = SP – BV4






Solution: First cost = $200,000 Selling price = $20,000 Depreciation: 3 years MACRS recovery period Book value at end of year 4 is zero Tax rate = 40%

CFAT1 - 3 = CFBT – TAXES = (GI – E) – (GI – E - D)(te) 1-3

CFAT4 = CFBT4 – TAXES4

=(GI – E + SP)4 – (GI – E – D + DR)4(te) =(GI – E + SP)4 – (GI – E – D + SP – BV)4(te)






Example 17.5, Blank (7th ed.), p.455

Example 17.6, Blank (6th ed.), p.583








7th Edition, 2012





7th Edition, 2012



CHEE 5369/6369

Homework # 4

Thursday February 13, 2014

The following solved examples from Blank (7th edition):

Example 17.1 page 447



lecture # 10 eva and disposal of assets

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