Question

Cost Cutting: CBD Inc, a processor of CBD oils, is analyzing a potential opportunity to cut costs. It can spend $1.5 Million today on the purchase and installation of a new automated processing line. The equipment will have a six-year life, at which time it can be sold for $250,000. The equipment qualifies as a Class 8 asset with a 20% CCA rate. Since the equipment will be purchased in 2020, it is subject to the Accelerated Investment Incentive rules, rather than the half-year rule. The benefit of installing the new equipment is a reduction in labour costs of $400,000 per year. The new process will lead to an immediate increase in Net Working Capital (NWC) of $25,000, which will be recovered at the conclusion of the project. The firm has a 30% corporate tax rate and it wants a 15% return. Should they undertake this cost-cutting program?

Calculate the PV of the after-tax incremental operating cash flows from undertaking the project.

a. $1,135,950

b. 1,366,245

c. 1,059,655

d. 1,263,755

Answer 1

Solution:

Initial cost = 1.5 million + 25,000 = 1.525 million

Terminal Cashinflow = 25,000 + 250,000 = 275,000

Depreciation calculation and it's Tax savings

Year	Opening balance	Depreciation	PVF @ 15%	PV of Tax savings
1	1,500,000	450,000 (30% x 1.5 million)	0.8696	117,391
2	1,050,000	210,000 (1.05 million x 20%)	0.7561	47,637
3	840,000	168,000 (840,000 x 20%)	0.6575	33,139
4	672,000	134,400 (672,000 x 20%)	0.5818	23,053
5	537,600	107,520 (537,600 x 20%)	0.4972	16,037
6	430,080	86,016 (430,080 x 20%)	0.4323	11,156
6	344,064	94,064 (loss on sale)	0.4323	12,200
	Total			260,613

Note :

PVF = Present Value Factor

PV of tax savings = Depreciation x Tax rate x PVF

Savings in Cost = $400,000 x (1-tax rate) x PVAF @15% for 6 years

= $400,000 (1-0.3) x 3.7845

= $1,059,655

Note :

All operating cost are taken as year end Cashflows

Cost savings after tax = Cost savings x (1-tax rate) x Present value annuity factor @15% for 6 years

Net present value = Cost savings + Depreciation savings + Present value of terminal cashflow - Initial cashoutflow

= $260,613 + $1,059,655 + $275,000 x 0.43233 - 1.525 million

= -85,841.2

NPV is negative, so we should not undertake the project

The asset is sold at the end of 6 years at estimated price and the balance is taken as loss for that year (assumed)

Declining balance method is used instead of Straight line of depreciation. (assumed)