Question

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?

Answer 1

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.