Question

FBR Corporation has just finished minor renovations on their office building at a cost of $150,000. FBR originally allocated only $100,000 for this renovation. A memo from accounting suggests that the $50,000 cost overrun should be charged to the next new project the company will implement.

As its next project, FBR Corp. is considering the acquisition of a new machine that would replace one of their old machines in use. The new machine costs $0.9 million (t=0), and it can be sold at the end of its expected 4-year operating life for $300,000. The new machine takes up more space and GEC will need to move maintenance and cleaning supplies that used to be stored next to the machine to a small storage room that could otherwise be sublet for $25,000 a year (at t=1 to t=4). The old machine was bought 8 years ago for $800,000 and can be sold for $300,000 today or for $150,000 in 4 years. FBR paid $25,000 for a study which indicates that the new machine will reduce manufacturing costs by $220,000 annually. Moreover, net working capital will be reduced by $150,000 when the new machine is installed, and will increase again by $150,000 at the end of the machine’s operating life. Both machines belong to asset class 43 with a CCA rate of 30%. FBR’s marginal tax rate is 40%, and it uses a discount rate (required rate of return, RRR) of 14% to evaluate projects of this nature.

What is the initial cash outlay (the total cash flow at t=0)?

What is the first year’s cash flow (excluding the CCA Tax Shield)?

What is the last year’s cash flow (excluding the CCA Tax Shield)?

What is the year 3 CCA?

What is the PV CCA Tax Shield?

What is the NPV of the replacement project?

Should FBR Corp. replace the old machine with the new one?

Answer 1

Solution:

Information from the Problem is as follows,

New Machine cost	$900,000
Old Machine price (today)	$300,000
Salvage Value (new machine)	$300,000
Salvage Value (old machine)	$150,000
Expected life of machine	4 Yrs
Purchase new machine	$900,000
less: Sale old machine	($300,000)
Net new depreciable asset	$600,000

Salvage value for new machine in 4 years	$300,000
Salvage value for new machine in 4 years	($150,000)
Net salvage value	$150,000

Reduction in Production costs per year (fixed) = $220,000
Reduction in Working Capital (year 0) = $150,000
incremental project related cash flows = $25,000
Corporate tax rate = 40%
CCA rate (class 43) = 30%
RRR = 14%

Calculation of the Intial Cash Outlay at t = 0:

The initial cash outlay (the total cash flow at t = 0) = $600,000 - $150,000

The initial cash outlay (the total cash flow at t = 0) = $450,000.

Calculation of the First Year's Cash Flow (Excluding the CCA Tax Shield):

Savings in cost	$220,000
Less: Incremental flows	($25,000)
The First year’s cash flow (excluding the CCA Tax Shield)	$195,000

Calculation of the Last Year's Cash Flow (Excluding the CCA Tax Shield):

Cash flows	$195,000
less: net working capital	($150,000)
Add: Salvage value of old equipment	$150,000
The Last year’s cash flow (excluding the CCA Tax Shield)	$195,000

Calculation of the Year 3 CCA:

Undepreciated cost capital :
year 0 = 600,000 - depreciation (600,000 * 30% * 0.5 = 90,000) = $510,000
Year 1 = 510,000 - (510,000 * 30% = 153,000) = $357,000
Year 3 = 357,000 - (357,000 * 30% = 107,100) = $249,900
Capital cost allowances for year 3 = $107,100