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11-10. Red Rock Lobster (RRL) is looking to expand its business. The new business would generate...

11-10. Red Rock Lobster (RRL) is looking to expand its business. The new business would generate $2.5 million per year in sales over the next 5 years. Annual costs would increase by $2.1 million. An investment in working capital of $50,000 would have to be made initially. The machinery (CCA rate of 30%) would cost $700,000, with additional costs of $10,000 and $20,000 to be incurred for setup and training. RRL estimates that it would be possible to sell the equipment for 10% of its initial value at the end of 5 years. The company would set up operations in a building it does not use but does rent out for $100,000 per year. If RRL's cost of capital is 12% and its tax rate is 28%, should it proceed with this new business?

11-13. Central Drug Mart (CDM) is a drugstore chain operating in Ontario and Quebec. The company is contemplating a home delivery service for its prescription drug sales to customers who are unable to pick up their drugs in the stores. CDM is investigating whether to invest in small hybrid automobiles. The new delivery service is forecast to increase prescription drug sales by $500,000 per year. CDM's total variable costs are 60% of sales. CDM will also charge a nominal delivery fee of $3 per delivery.

The new hybrid fleet would cost $890,000 and would have an economic life of 7 years, after which time the salvage value would be $40,000. The company expects to make 13,000 deliveries per year.

On further investigation, CDM finds that the new vehicles would save $60,000 per year in fuel costs compared to regular gasoline-powered vehicles. Spare parts inventory of $30,000 would have to be purchased. Assume that the spare parts inventory is purchased at t=0 .

(a) CDM typically uses a 12% cost of capital. Its tax rate is 30%, and the vehicles fall into a CCA class of 30%. What is the NPV of this fleet delivery project?

(b) If the federal government changed the CCA rate to 50% for hybrid vehicles to encourage their use, what would the NPV of the project now be?

11-14. Saint John River Shipyards is considering replacing an old riveting machine with a new one that will increase earnings before depreciation from $34,500 to $54,000 per year. The new machine will cost $92,500, and it will have an estimated life of 8 years with an estimated salvage value of $6,500. The new machine falls into Class 43, which has a 30% CCA rate. The company is taxed at 30% and its WACC is 12%. If replaced today, the old machine could be sold for $4,000. If the old machine is kept, it will have no salvage value in 8 years. Should they replace the old riveting machine?

11-16. Taylor Corporation currently uses an injection-moulding machine that was purchased 2 years ago. The CCA rate on this machine is 30%. Currently, it can be sold for $2,500. If this old machine is not replaced, it is not expected to have any value at the end of its useful life, estimated to be 6 years from now.

Taylor is offered a replacement machine that has a cost of $12,000, an estimated useful life of 6 years, and an estimated salvage value of $1,200. The CCA rate on this machine is also 30%. The replacement machine would permit an output expansion, so sales would rise by $1,400 per year; also, the new machine's much greater efficiency would reduce operating expenses by $1,500 per year. The new machine would require that inventories be increased by $2,000, but accounts payable would simultaneously increase by $1,000. Taylor's tax rate is 30% and its WACC is 12%. Should the company replace the old machine?

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Expert Solution

Q.no. 11 - 10:

Calculation of present value of cash outflows:

Machinery cost = $7,00,000

Setup costs. = $10,000

Training costs. = $20,000

Total capital outlay = $7,30,000

Working capital = $50,000

Total present value of cash outflows = $$7,80,000 [7,30,000+50,000]

Calculation of present value of operating cash inflows:

Particulars year 1 2 3 4 5
Annual sales 25,00,000 25,00,000 25,00,000 25,00,000 25,00,000
Less:Annual costs 21,00,000 21,00,000 21,00,000 21,00,000 21,00,000
Operating income 4,00,000 4,00,000 4,00,000 4,00,000 4,00,000
Less: Opportunity cost (Rent) 1,00,000 1,00,000 1,00,000 1,00,000 1,00,000
Less: Depreciation@30% 2,19,000 1,53,300 1,07,310 75,117 52,582
EBIT 81,000 1,46,700 1,92,690 2,24,883 2,47,418
Less: Tax@28% 22,680 41,076 53,953 62,967 69,277
EAT 58,320 1,05,624 1,38,737 1,61,916 1,78,141
Add: Depreciation 2,19,000 1,53,300 1,07,310 75,117 52,582
CFAT 2,77,320 2,58,924 2,46,047 2,37,033 2,30,723
[email protected]%[Note] 0.9205 0.8473 0.7799 0.7179 0.6608
Present value of cash inflows 2,55,273 2,19,386 1,91,892 1,70,166 1,52,462

Total present value of cash inflows = $9,89,179

Calculation of present value of Terminal cash inflows:

Salvage value of the machine = $73,000 [7,30,000×10%]

Working capital. = $50,000

Total terminal cash inflows = $1,23,000

Present value of Terminal cash inflows

$1,23,000×PVF(8.4%,5)

= 1,23,000×0.6608

= $81,278

Net present value = present value of operating cash inflows + present value of Terminal cash inflows - present value of cash outflows

NPV = 9,89,179+81,278-7,80,000

= $2,90,457

Conclusion: As the NPV is positive, company can proceed with investment in new business.

Note: For cost of capital, post tax cost of capital has been taken i.e.,12(1-0.28) = 8.64%.

Q.no. 11 - 13:

(a) Calculation of present value of cash outflows:

cost of new hybrid fleet. =. $8,90,000

Cost of spare parts of Inventory = $30,000

Total present value of cash outflows = $9,20,000

Calculation of present value of operating cash inflows:

Particulars year 1 2 3 4 5 6 7
Sales 500000 500000 500000 500000 500000 500000 500000
Less: variable cost @60% 300000 300000 300000 300000 300000 300000 300000
Operating income 200000 200000 200000 200000 200000 200000 200000
Add: Delivery fee@3per delivery 39000 39000 39000 39000 39000 39000 39000
Add: savings on fuel costs 60000 60000 60000 60000 60000 60000 60000
EBIDT 299000 299000 299000 299000 299000 299000 299000
Less: Depreciation@30% 267000 186900 130830 91581 64107 44875 31412
EBIT 32000 112100 168170 207419 234893 254125 267588
Less: Tax@30% 9600 33630 50451 62226 70468 76237 80276
EAT 22400 78470 117719 145193 164425 177888 187312
Add: Depreciation 267000 186900 130830 91581 64107 44875 31412
CFAT 289400 265370 248549 236774 228532 222763 218724
[email protected]% 0.9225 0.8510 0.7851 0.7242 0.6681 0.6163 0.5686
Present value 266971 225830 195136 171472 152682 137289 124366

Total present value of operating cash inflows = $1273746

Calculation of present value of Terminal cash inflows:

Salvage value of hybrid fleet = $40,000

Present value of terminal cash inflows

= 40,000×PVF(8.4%,7)

= 40,000×0.5686

= $22744

Net present value = 1273746+22744-920000

NPV = $$3,76,490

Conclusion: As the NPV is positive, company can invest in the project.

(b) If government charges CCA rate @50%

Calculation of present value of cash outflows:

present value of cash outflows = $9,20,000

Calculation of present value of operating cash inflows:

Particulars year 1 2 3 4 5 6 7
EBDIT 299000 299000 299000 299000 299000 299000 299000
Less: Depreciation@50% 445000 222500 111250 55625 27812 13906 6953
EBT (146000) 76500 187750 243375 271188 285094 292047
Less: Tax@30% 43800 (22950) 56325 73012 81356 85528 87614
EAT (102200) 53550 131425 170362 189832 199566 204433
Add: Depreciation 445000 222500 111250 55625 27812 13906 6953
CFAT 342800 276050 242675 225987 217644 213472 211386
[email protected]% 0.9225 0.8510 0.7851 0.7242 0.6681 0.6163 0.5686
Present value 316233 234918 190524 163660 145408 131563 120194

Total present value of operating cash inflows

= $1302500

Calculation of present value of Terminal cash inflows:

Present value of terminal cash inflows = $22744

Net present value = 1302500+22744-920000

NPV = $405244

Conclusion: As NPV is positive, accept the project

Note: post tax cost of capital has been taken

Q.no. 11 - 14:

Calculation of present value of cash outflows:

Cost of new equipment = $92,500

Less:Sale proceeds on old machine. =($4,000)

Net cash outflows. = $88,500

Present value of cash outflows = $88,500

Calculation of present value of operating cash inflows:

Depreciation has been increased from $34,500 to $54,000 i.e., incremental depreciation = $19,500

Depreciation = $19,500

Tax shield@30%. = $5,850

CFAT p.a. [(5,850)+19,500] = $13,650

Present value of operating cash inflows

= 13,650×PVAF(12%,8)

= 13,650×4.9676

=$67,808

Present value of Terminal cash inflows:

Salvage value of equipment = $6,500

Present value of terminal cash inflows

= 6,500×PVF(12%,8)

= 6,500×0.4039

= $2625

NPV = 67,808+2,625-88,500

NPV = (18,067)

Conclusion: As NPV is negative, it is better not to replace the old machine.

jeff jeffy answered 2 years ago
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