Question

NDA Inc. is considering a project which requires the purchase of a $160,000 machine. The CCA rate is 30%. When the project ends at year 7, its residual value is expected to be $18,000. This machine is the only asset in the asset class which terminates when the project ends. The project is expected to generate before tax cash flow of $38,000 per year for 7 years. If the project is all financed by equity, the cost of capital would be 12%. The corporate tax rate is 35%. NDA only has $70,000 available and DT bank is willing to provide a loan for the balance at a subsidized rate of 3% which is 2% lower than borrowing cost of NDA. However, the bank will charge 5% of the amount borrowed as flotation costs and require NDA to repay one third of the loan at the end of years 2, 4, and 7. Using the adjusted present value method, determine whether NDA should undertake the project. [Keep at least 2 decimal places for dollar amounts and 4 decimal places for rates] ***CCA with 50% rule

Answer 1

CCA depn. Wkgs.
Year	Depn. Amt.	Book Value		Depn.*Tax rate 35%
0		160000
1	24000	136000	160000*30%/2	8400
2	40800	95200		14280
3	28560	66640		9996
4	19992	46648		6997.2
5	13994.40	32653.6		4898.04
6	9796.08	22857.52		3428.63
7	6857.26	16000.26		2400.04

AT salvage
Residual value	18000
Book value	16000.26
Gain on salvage	1999.74
Tax on gain 1999.74*35%)	-699.91
ATCF on salvage (18000-699.91)	17300.09

Interest tax shields workings

Borowings needed= 160000-70000=90000

As the bank charges 5% as flotation cost,

they need to borrow, 90000/95*100= $ 94736.84

Loan repayment schedule is as follows

Year	Tow. Int.	tow. Loan	Loan bal.	Int*Tax rate 35%
0			94736.84
1	2842.105	0	94736.84	994.74
2	2842.105	31578.95	63157.89	994.74
3	1894.737	0	63157.89	663.16
4	1894.74	31578.95	31578.95	663.16
5	947.37	0	31578.95	331.58
6	947.37	0	31578.95	331.58
7	947.37	31578.95	0	331.58
		94736.84

Year	0	1	2	3	4	5	6	7
1.Before-tax cash flows		38000	38000	38000	38000	38000	38000	38000
2.Tax at 35%		-13300	-13300	-13300	-13300	-13300	-13300	-13300
3.Add: Depn.tax shields		8400	14280	9996	6997.2	4898.04	3428.63	2400.04
4.ATCF on salvage								17300.09
5.Initial cost	-160000
6.Total Unlevered ATCFs(sum 1 to 6)	-160000	33100	38980	34696	31697.2	29598.04	28128.63	44400.13
7.PV F at 12%(1/1.12^yr.n)	1	0.89286	0.79719	0.71178	0.63552	0.56743	0.50663	0.45235
8.PV at 12% (6*7)	-160000	29553.57	31074.62	24695.93	20144.14	16794.72	14250.84	20084.36
9.NPV at 12%(sum of row 8) ----------1	-3401.82
10.Interest tax shields(Ref. wkgs.)		994.74	994.74	663.16	663.16	331.58	331.58	331.58
11.PV F at cost of debt3%		0.97087	0.94260	0.91514	0.88849	0.86261	0.83748	0.81309
12.PV at 3% (10*11)		965.76	937.63	606.88	589.21	286.02	277.69	269.60
13.NPV of Int.tax shields(sum of Row 12)----2	3932.81
14.Adjusted present value of the project(9+13)- ----(1+2)	530.99

Based on above, as NPV under the APV is POSITIVE,

NDA can undertake the project