Question

A proposed cost-saving device has an installed cost of $720,000. It is in Class 8 (CCA rate = 20%) for CCA purposes. It will actually function for five years, at which time it will have no value. There are no working capital consequences from the investment, and the tax rate is 35%.

a. What must the pre-tax cost savings be for us to favour the investment? We require an 12% return. (Hint: This one is a variation on the problem of setting a bid price.) (Do not round your intermediate calculations. Round the final answer to 2 decimal places. Omit $ sign in your response.)

Cost savings           $

b. Suppose the device will be worth $100,000 in salvage (before taxes). How does this change your answer? (Do not round your intermediate calculations. Round the final answer to 2 decimal places. Omit $ sign in your response.)

Cost savings           $

Answer 1

Installed cost = 720,000

Life = 5 years

Tax rate = 35%

Rate of return = 12%

Answer 1

To accept the investment the NPV should be atleast 0 or above,

putting the above into an equation we will get

720000=post tax cost savings x Present value annuity factor

Present value annuity factor of 12% for 5 year is 3.604 (from present value annuity table)

Hence the post tax cost savings = 720000/3.604

That is 199778

Pre tax cost savings = 199778/.65

that is 307350.8

Answer 2

Here the salvage value given as 1,00,000

after tax salvage value = 100000 x .65

that is 65000

Now the present value of salvage value 5 year from = 65000x present value factor @12%, 5year

that is 65000 x .567 = 36855

So we will reduce it from the installed cost and now the previous equation will be

720000-36855=post tax cost savings x Present value annuity factor

Present value annuity factor of 12% for 5 year is 3.604 (from present value annuity table)

Hence the post tax cost savings = 683145/3.604

That is 189551.9

hence, pre tax cost savings = 189551.9/.65

that is 291618.3