Question

Precision Mechanical is considering purchasing a robotic system at a cost of $250,000. There will be additional costs for installation and modification totalling $14,000. Use of the system will reduce annual labour costs of $200,000 by 25%. Product defects will also be reduced, saving the company $18,000 per year. Precision will need to increase net operating working capital by $5,000. The company has decided that the robot can be located in a part of the factory that is currently underutilized and is undergoing a $20,000 upgrade for a separate project. The robotic system has an expected life of 6 years, at which time it will have a salvage value of $40,000. Precision Mechanical has a weighted average cost of capital of 13%. The applicable corporate tax rate is 35% and the CCA rate is 20%. The company will be financing the system with a 6-year bank loan with annual year-end payments of $57,000, (consisting of both interest and principal).

Determine if precision mechanical should purchase this equipment.

Answer 1

ANSWER

Capital cost allowance calculation is the key part of this question. CCA can be taken only half of the permissible amount in first year, i.e. 10% in year 1. Also note that it is the only depreciation expense. See the calculations below:

Project cost	250000
Annual labour costs	200000
Expected life (years)	6
Salvage value	40000
WACC	13%
tax rate	35%
Capital cost allowance (CCA) rate	20%
Year	0	1	2	3	4	5	6
Project value at beginning		250000	225000	180000	144000	115200	92160
CCA		25000	45000	36000	28800	23040	18432
Ending balance	250000	225000	180000	144000	115200	92160	73728
Depreciation tax shield		8750	15750	12600	10080	8064	6451.2
Year	0	1	2	3	4	5	6
Investment	-250000
Installation and modification cost	-14000
Loan financing	264000
Labour cost savings		50000	50000	50000	50000	50000	50000
savings from less defects		18000	18000	18000	18000	18000	18000
Increase in working capital		-5000	-5000	-5000	-5000	-5000	-5000
loan repayment		-57000	-57000	-57000	-57000	-57000	-57000
Depreciation tax shield		8750	15750	12600	10080	8064	6451.20
Net cashflow	0	14750	21750	18600	16080	14064	12451.20
Present value of cashflow	0	13053.10	17033.44	12890.73	9862.17	7633.38	5980.54
Total present value	66453.35

Since the Total present value is 66453.4, the project will generate benefit for the company. Hence it should be accepted.

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