Question

1. A proposed cost-saving project requires a device with an installed cost of $540,000. The project will last for five years. The device has a CCA rate of 20%. The required initial net working capital investment is $20,000, the marginal tax rate is 37%, and the required return on the project is 11%. The device has an estimated salvage value of $95,000 at the end of Year 5, and the net working capital investment will also be recovered at the end of Year 5. What level of pre-tax cost savings do we require for this project to be profitable?                                                       

Answer 1

The cash flows for 5 years are as below :

Depreciation in each year = (installed cost - cumulative depreciation) * 20%

OCF = income after tax + depreciation

Cumulative depreciation upto year 5 = $363,053

book value of device at end of year 5 = $540,000 - $363,053 = $176,947

tax advantage on sale of device = ($176,947 - $95,000) * 37% = $30,320

After tax salvage value = $95,000 + $30,320 = $125,320

Now, the NPV is calculated using NPV function in Excel

We initially use a pre-tax cost savings of $150,000. This results in a negative of NPV of -$20,661

We increase the pre-tax cost savings to $160,000. This results in a positive NPV of $2,623

With some trial-and-error, we can see that the NPV becomes positive at a pre-tax cost savings of $158,874

Level of pre-tax cost savings required for this project to be profitable is $158,874