In: Accounting
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 labor 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?
What is the correct value for Step #1-#6? ?(Value for each Step) Should they accept or reject? Is the NPV positive or negative?
All amounts are in $
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
= -85,841.25
Negative NPV, so we should not undertake the project
Assumed that the asset is sold at the end of 6 years at estimated price and the balance is taken as loss for that year.
Also assumed to use Declining balance method instead of Straight line of depreciation.