Question

Use the information below for questions 37-40

Rocky Mountain Brewery has done an analysis of whether to continue offering a new product or
to halt operations for $250,000. The new product has expected sales at the end of this year of
$800,000 and this will continue for two years after that (3 years total). This product has created
some cannibalization worth $100,000 of sales reduction each year. COGS is $200,000 per year
and COGS related to the cannibalized product is $60,000 each year. Based on this analysis the
sales and COGS values will stay consistent for this upcoming year-end and the next two years.
Interest charges are $70,000 annually. The corporate tax rate is 25%. The equipment cost for the
project is $1,000,000 and was spent at the beginning of this year (t=0) and it has a 40% CCA
rate. Assume that at the end of year 3 the equipment is sold for $0 and does not bring any tax
consequences.

37. What is the PV of the CCA tax shield?
a. $92,349
b. $100,797
c. $142,583
d. $145,658

38. What is the Net Income in year 3?
a. $270,000
b. $306,000
c. $292,000
d. $276,000

Accounts receivable are expected to account for 7% and accounts payable are expected to
account for 8% of COGS. The networking capital will be recovered at the end of year 3. The
firm demands a 12% return on projects such as this.

39. What is the NPV of the new product introduction?
a. $18,014
b. $176,070
c. $136,070
d. $144,109

40. A comparable company for this product, Foothills Brewery Ltd., had EBIT of $40,000,
50,000 and 60,000 for the end of this year and the following two years (years as above).
Depreciation incorporated into each year’s EBIT is $300,000. The appropriate CCA rate
was also 40% on a $1M investment, there do not have an interest expense and the tax rate
was also 25%. How would you adjust the values in year 2 to receive net income that you
are able to compare to the Rocky Mountain Brewery net income in year 2? That is, what
is the NI in year 2 for the Foothills Brewery Ltd.?
a. $22,500
b. $20,900
c. -$45,500
d. $33,200

Answer 1

Year	Depn.	Book value	Tax shield	PV of Tax shield
1	2=Prev.3*40%	3=Prev.3-current depn.)	4=2*25%	5=4/1.12^Yr.n
0		1000000
1	200000	800000	50000	44642.86
2	320000	480000	80000	63775.51
3	192000	288000	48000	34165.45
				142583.82

Note: Yr. 1 depn. Is 50% of 40% *1000000

ANSWER: c.

37.PV of the CCA tax shield= $ 142583

38 & 39 Year	0	1	2	3
Sales		800000	800000	800000
Cannibalised sales		-100000	-100000	-100000
COGS		-200000	-200000	-200000
COGS saved		60000	60000	60000
Depn.		-200000	-320000	-192000
EBIT		360000	240000	368000
Tax at 25%		-90000	-60000	-92000
Net income		270000	180000	276000	Ans.-38
Add back; depn.		200000	320000	192000
1.Operating cash flow		470000	500000	468000
2.Cost of eqpt.	-1000000
Net working capital
Accounts receivable(7%*(-200000+60000))	-9800
Accounts payable(-8%*(-200000+60000))	11200
3.Net NWC	1400			-1400
4.Total annual FCFs(1+2+3)	-998600	470000	500000	466600
5.PV F at 12%(1/1.12^Yr.n)	1	0.89286	0.79719	0.71178
6.PV at 12%(4*5)	-998600	419642.86	398596.94	332116.66
7.NPV (sum of row 6)	151756.46	Ans.39

40..
Year	0	1	2	3
EBIT		40000	50000	60000
Tax at 25%		-10000	-12500	-15000
Net income		30000	37500	45000