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 Reserved8
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:
10 © 2012 by McGraw-Hill, New York, N.Y All Rights Reserved
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

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 Reserved31
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.
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 PorSP 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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