Introduction to Financial Management

Classroom Learning Problems

Problem: Share Price Maximization (for discussion)

[Note: this is the same as the problem set.]

Rita Wexler is the CFO of Augusta Inc. Augusta’s common shares are thought to be
worth $37.65 per share based on estimated future cash flows of $3.20 per share in
perpetuity and a cost of capital of 8.5%. A new U.S. competitor has entered the market,
so Wexler now believes Augusta’s cash flows per share will fall to $2.85 per share and its
cost of capital will rise to 9.5% because of additional risk.

For class discussion:

1. What is meant by “future cash flows of CAD 3.20 per share in perpetuity”?
2. What does “cost of capital” mean?

REQUIRED:

1. What effect will these changes have on Augusta’s share price?

If the return is 8.5% and the annual payment is $3.20, then this must represent the
interest on the amount/value. So
3.2 = 8.5% × Value → Value = $37.65

Now if the return changes to 9.5% and the annual payment is $2.85:
2.85 = 9.5% × Value → Value = $30.00

The value falls to $30 per share for two reasons: reduced payment and higher cost of
capital.

2. What is Augusta’s RRR and how does it relate to its cost of capital?

The required rate of return is the cost of capital. If your money costs a certain amount
(cost of capital), then you need to earn this return on the investment you make with this
amount of money (required return).

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Problem: Average and Marginal Tax Rates

Harry Blanc is a BC resident and earned CAD 70,000 last year. The tax rates and brackets
federally and provincially were:

15.00% Up to $48,535
20.50% $48,536 to $97,069
Federal
26.00% $97,070 to $150,473
government
29.00% $150,474 to $214,368
33.00% $214,369 and over

5.06% Up to $41,725
7.70% $41,726 to $83,451
British 10.50% $83,452 to $95,812
Columbia 12.29% $95,813 to $116,344
14.70% $116,345 to $157,748
16.80% $157,749 and over

REQUIRED:

Let’s start by interpreting what the table above is telling us. For example, along the 29%
row in the “Federal government” table, it means that for every dollar earned between
$150,474 and $214,368, you pay 29% (or 29 cents) for every dollar earned. So by
definition this table is showing marginal tax rates.

1. What was Blanc’s average tax rate?

The average tax rate is simply the “average rate paid for the entire amount of earnings”.
So it is simply calculated as (total taxes paid)/(total earnings).

Let’s calculate this for the federal tax. To be clear, the “total earnings” are $70,000. Now
we have to calculate the total tax:

Here’s the calculation:

Total Tax Tax
Tax Rates Tax Brackets (at beginning of (within the
range) range)
Federal 15.00% Up to $48,535 7,280.25
government 20.50% $48,536 to $70,000 7,280.25 4,400.33

So up to $48,535, the rate is 15%, so since Harry is earning more than that, he is paying
the full amount of 15%(48,535) = $7,280.25 for that range.
In addition, he earned another 70,000 – 48,535 = $21,465 in the 20.5% range, so the
taxes for that portion are 20.5%(21,465) = $4,400.33 for that range.
The total taxes to be paid are then $7,280.25 + $4,400.33 = $11,680.58.
Now we can calculate the average rate for the federal taxes:
11,680 / 70,000 = 16.69%

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Using the same methodology, the total provincial tax is $4,288.46, resulting in an
average provincial tax rate of 6.13%

2. What was Blanc’s marginal tax rate?

As noted above, the table provides us with marginal rates. So the answer here is simple:
the marginal federal rate is 20.50% and the marginal provincial rate is 7.70%.

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Problem: Effective Tax Rates on Capital Gains and Dividends

Mary Poppins earned CAD 20,000 in capital gains on the sale of shares and CAD 10,000
in dividend income. Poppins resides in BC and earned CAD 100,000 last year.

15.00% Up to $48,535
20.50% $48,536 to $97,069
Federal
26.00% $97,070 to $150,473
government
29.00% $150,474 to $214,368
33.00% $214,369 and over

5.06% Up to $41,725
7.70% $41,726 to $83,451
British 10.50% $83,452 to $95,812
Columbia 12.29% $95,813 to $116,344
14.70% $116,345 to $157,748
16.80% $157,749 and over

The Federal Dividend Tax Credit and Provincial Dividend Tax Credit are 15.02% and
8.00% of Grossed-up Dividends. Dividends are grossed up at a rate of 38%.

For class discussion:

Process:
1. 50% of capital gains are taxed.
2. We first gross up the dividends and then calculate the taxes and credits on those
grossed-up dividends.
3. Then the tax credits are calculated.

REQUIRED:

1. What is the effective tax rate on the capital gains earned?

The earnings in this example are on top of the $100,000 that Mary has earned, so we are
dealing with marginal taxes here. (Taxes on the extra earned, not starting from zero.)

For capital gains taxes, only 50% of the gains are taxed, so that effectively reduced the
tax rate to half of the marginal rate. So Mary will pay ½ of 26.00%, or 13% for the federal
tax and ½ of 12.29%, or 6.145% for the provincial tax.

2. What is the effective tax rate on the dividend income earned?

Dividends are a bit more complicated.

a. First we gross up: as far as the calculation goes, this is like “pretending that the
dividend income is higher by the gross-up amount”. So that means we add 38%
to the income.

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 b. Then we calculate the marginal federal and provincial taxes on the grossed-up
income (here $13,800). That gives us the total amount before dividend tax
credits.
c. Finally, we calculate the federal and provincial dividend tax credits on the basis of
the grossed-up income. Here that means 15.02% and 8.00% of the $13,800. That
will be subtracted from the taxes payable calculated in (b) above.

This is what the calculation looks like:

Dividends 10,000
Gross-up (38% of dividend income) 3,800
Grossed-up dividend 13,800
Federal tax (26% of grossed-up) 3,588.00
Provincial tax (12.29% of grossed-up) 1,696.02
Total personal income tax 5,284.02
Federal dividend tax credit 2,072.76
Provincial dividend tax credit 1,104.00
Total corporate tax paid 3,176.76
Taxes payable 2,107.26
Effective tax rate 21.07%

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Problem: Capital Cost Allowance at Elder

Elder Industries purchased new equipment for CAD 600,000 plus taxes of CAD 60,000
and CAD 40,000 in transportation and installation expenses. The asset is in a CCA class
with a rate of 20% which is subject to the half-year rule. Elder received a 10%
investment tax credit on the asset purchase. Other assets in this class were sold for CAD
50,000. The class had a UCC of CAD 2,400,000 at the beginning of the year.

What we need to understand

1. First of all, what do CCA and UCC represent
2. What is the total value of the acquisition (and the role of the investment tax credit)
3. What is the total value of the net acquisitions
4. Using the half-year (or accelerated) rule
5. Calculating the UCC at the beginning of the second year

REQUIRED:

1. Determine the CCA deduction for the CCA class for the next two years.
Going through this step-by-step:
a. The acquisition cost includes taxes and shipping: so it is $700,000 before
considering the tax credit.
b. Now considering the tax credit, Elder will effectively only pay 90% (instead of
100%) of these costs, so the cost – and therefore, the addition to the UCC – is
90%($700,000) = $630,000
c. Disposals during the year were $50,000, so the net acquisitions were $630,000 -
$50,000 = $580,000.
d. Using the half-year rule, we would then calculate the CCA for the net
acquisitions on the basis of half of the their value, so ½($580,000) = $290,000.
e. Now we can calculate the CCA for the year: We have $2,400,000 and the
additional $290,000 that we calculate using the 20% rate for the CCA class:
20%(2,690,000) = $538,000.
f. Our UCC was $2,400,000 and we had net acquisitions of $580,000, giving us a
total of $2,980,000 and now we have CCA of $538,000. So we will end year 1 with
(and begin year 2 with) UCC of $2,980,000 – $538,000 = $2,442,000.
g. For year 2, the calculation is easier because we don’t have any net acquisitions.
So the CCA = 20%(2,442,000) = $488,400 leaving us with a UCC of $1,953,600.
Year Beginning UCC Net Acq. CCA Ending UCC
1 2,400,000 580,000 538,000 2,442,000
2 2,442,000 0 488,400 1,953,600

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The above uses the half-year rule. If we use the accelerated rule, steps a–c are the same,
but now we need to use 1.5x instead of ½ for the first year:
d. Using the accelerated rule, we would then calculate the CCA for the net
acquisitions on the basis of half of the their value, so 1.5($580,000) = $870,000.
e. Now we can calculate the CCA for the year: We have $2,400,000 and the
additional $870,000 that we calculate using the 20% rate for the CCA class:
20%(3,270,000) = $654,000.
f. Our UCC was $2,400,000 and we had net acquisitions of $580,000, giving us a
total of $2,980,000 and now we have CCA of $654,000. So we will end year 1 with
(and begin year 2 with) UCC of $2,980,000 – $654,000 = $2,326,000.
g. For year 2, the calculation is easier because we don’t have any net acquisitions.
So the CCA = 20%(2,326,000) = $465,200 leaving us with a UCC of $1,860,800.
Year Beginning UCC Net Acq. CCA Ending UCC
1 2,400,000 580,000 654,000 2,326,000
2 2,326,000 0 465,200 1,860,800

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Problem: Capital Cost Allowance at Crampoon

Crampoon Enterprises purchased a new building for CAD 2,000,000. The asset is in a
CCA class with a rate of 5% that is subject to the half-year rule. Under the ITA, all
buildings are put in separate classes and not pooled with other assets. The corporate
tax rate is 30%.

REQUIRED:

1. Determine the CCA deduction for the next two years.

Here we don’t have any beginning UCC. So the calculation is straightforward for the first
two years:
Year 1: CCA = ½(2,000,000)(5%)=$50,000
UCCend = 2,000,000 – 50,000 = $1,950,000
Year 2: CCA = 1,950,000(5%)=$97,500
UCCend = 1,950,000 – 97,500 = $1,852,500
Year Beginning UCC Net Acq. CCA Ending UCC
1 0 2,000,000 50,000 1,950,000
2 1,950,000 0 97,500 1,852,500

2. What are the tax consequences if the building is sold for CAD 1,800,000 at the
beginning of the third year? What if it was sold for CAD 1,900,000?
We compare the sales price to the book value at the time of sale: so if we sell for
$1,800,000 that means there is a loss of 1,852,500 – 1,800,000 = $52,500. That would
result in a tax benefit of 30%(52,500) = $15,750

3. What would be the CCA deduction under the accelerated depreciation rule?
Year 1: CCA = 1.5(2,000,000)(5%)=$150,000
UCCend = 2,000,000 – 92,500 = $1,850,000
Year 2: CCA = 1,850,000(5%)=$97,500
UCCend = 1,850,000 – 92,500 = $1,757,500
Year Beginning UCC Net Acq. CCA Ending UCC
1 0 2,000,000 150,000 1,850,000
2 1,850,000 0 92,500 1,757,500

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Problem: Loss Carrybacks and Carryforwards at Blokey

Blokey Inc. has been in operation for four years. Its taxable income (loss) over those
years was:

Year 1 Year 2 Year 3 Year 4

Taxable income (loss) (CAD 200,000) (CAD 85,000) CAD 110,000 CAD 500,000

The income tax rate is 25.0%.

Loss Carrybacks and Carryforwards

From the class reading: if the losses cannot be fully applied in the past three years due
to insufficient income, they can be carried forward for up to 20 years resulting in lower
income taxes in those years.

REQUIRED:

1. What income tax expense will be incurred by Blokey at the end of year 4?

Blokey starts year 4 with 200k + 85k – 110k = $175,000 of tax losses that can be carried
forward and can be applied to year 4.

The taxable income in year 4 with thus be 500,000 – 175,000 = $325,000.

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