Question

A proposed cost-saving device has an installed cost of $645,000. The device will be used in a five-year project, but is classified as manufacturing and processing equipment for tax purposes. The required initial net working capital investment is $55,000, the marginal tax rate is 35%, and the project discount rate is 9%. The device has an estimated year 5 salvage value of $75,000. What level of pre-tax cost savings do we require for this project to be profitable? The CCA rate is 20%.

Answer 1

As it is the level of pre-tax cost savings required,

we leave out the tax effects on all cash flows, ie. Annual cost savings as well as salvage value.

So, forming an equation of the cash flows , for NPV=0

suppose , "x"be the pre-tax annual cost savings,then,

-645000-55000+(x*3.88965)+(55000/1.09^5)+(75000/1..09^5)=0

P/A, i=9%,n=5 yrs.= 3.88965

we get the annual pre-tax cost savings for NO profit-no loss to be

$158,243

so, the annual pre-tax cost savings should be anything more than $ 158243 , to be profitable (ANSWER)

If it is after-tax, then the calculations are

-645000-55000+(x*(1-35%)*3.88965)+(55000/1.09^5)+(122724/1.09^5)=0

x=231182

ie.the annual after-tax cost savings should be anything more than $ 231182 , to be profitable

Workings for after-tax salvage
Year	Depn.at 20%	Asset book value
0		645000
1	129000	516000
2	103200	412800
3	82560	330240
4	66048	264192
5	52838	211354	BV at end Yr.5
		75000	Salvage
		136354	Loss on salvage
		47724	tax saved due to loss
		122724	after-tax salvage(75000+47724)