Question

Marvelous Mining Company (MMC) is negotiating for the purchase of a new piece of equipment for its current operations. MMC wants to know the maximum price that it should be willing to pay for the equipment. That is, how high must the price be that it should be willing to pay for the equipment to have an NPV of zero. You are given the following facts:

1. The new equipment would replace existing equipment that has a current market value of $35000.

2. The new equipment would not affect revenues, but before-tax operating costs would be reduced by $12500 per year for 5 years. These savings in costs would occur at year-end.

3. The old equipment is now five years old. It is expected to last another five years and to have no resale value at the end of those 5 years. It was purchased at $40000 and is being depreciated at a CCA rate of 30%.

4. The new equipment will also be depreciated at a CCA rate of 30%. MMC expects to be able to sell the equipment for $6000 at the end of five years. At that time, the firm plans to reinvest in new equipment in the same CCA pool.

5. MMC has profitable ongoing operations.

6. The appropriate discount rate is 14%.

7. The tax rate is 40%.

8. Assume net acquisition cost is positive.

Answer 1

Solution:

  

Calculation of Net Acquisition Cost
Revenue
Present Value of Revenue Note: 1	$        54,993
Cost
New Equipment Cost	$        35,000
Net Acquisition Cost		$            19,993

Working Note:

1)

Revenue Flow Calculation
Particular	Year 1	Year 2	Year 3	Year 4	Year 5
Cost Reduction before tax (A)	$        12,500	$            25,000	$          37,500	$          50,000	$          62,500
Depreciation of old Equipment (B) Note: 3	$          2,017	$              1,412	$                988	$                692	$                484
Depreciation of new Equipment (C) Note: 2	$        10,500	$              7,350	$            5,145	$            3,602	$            2,521
New Equipment Gain Note:2 (5883-6000)					$                118
Revenue Before Tax (A-B-C+D)	$              (17)	$            16,238	$          31,367	$          45,707	$          59,613
Tax Rate 40%	$                (7)	$              6,495	$          12,547	$          18,283	$          23,845
Revenue After Tax	$              (24)	$              9,743	$          18,820	$          27,424	$          35,768
Present Value Factor @14%	0.8772	0.7695	0.6750	0.5921	0.5194
Present value of Revenue	$              (21)	$              7,497	$          12,703	$          16,237	$          18,577
Total Revenue	$                                                                                                                               54,993

2)

New Equipment Depreciation CCA Rate 30%
Present value of Equipment	$          35,000
Year 1	$          10,500
Year 2	$            7,350
Year 3	$            5,145
Year 4	$            3,602
Year 5	$            2,521
Salvage Value/Book Value	$            5,882
Equipment Sold	$            6,000
Net Gain on sale (6000-5882)	$                118

3)

Old Equipment Depreciation CCA Rate 30%
Present value of Equipment (After 5 Years of usage )	$          6,723
Year 6	$          2,017
Year 7	$          1,412
Year 8	$              988
Year 9	$              692
Year 10	$              484

Conclusion:

The Net Acquisition Cost should not to more than $ 19,993. At $ 19,993 NPV is zero.

Key Points:

1) Depreciation is calculated on CCA (Capital Cost Allowance) rate which means depreciation is calculated on net amount of asset/ book value but not on purchase value of asset.

2) Decimal Points are not taken in calculation.