Question

MANAGEMENT ACCOUNTING 3 (318)

Question title (Investment)
Q1). Sundry Coal Company [SCC] is considering upgrading a large Coal mine. The mine was purchased five years ago for $ 20,000,000. A market research study just finished for $ 500,000 has estimated the following data. (Assume that the Company will have assets in class 8 for Perpetuity).

CURRENT OPERATIONS.

Cash Revenues $ 8,000,000.
Cash Expenses $ 4,000,000.

Undepreciated Capital Cost:
Class 8 - Equipment [CCA rate is 20%] $ 10,000,000.

Tax rate 30%.
Cost of Capital 8%.

PROPOSED UPGRADE - NEW ESTIMATES
Life of project                          6yrs
New Equipment                      $ 3,000,000.
Market research project
just completed.                         $ 500,000.

Revised Cash Revenues            $ 11,000,000.
Revised Cash Expenses             $ 3,500,000.

Salvage - New Equipment in six years $ 800,000.
Salvage - Old equipment in Six years $ 300,000.
Salvage - Old equipment- at time o (today) $ 600,000.

REQUIRED:
a) Calculate the initial investment ?
b) Calculate the present value incremental After-Tax cash flow?
c) Calculate the present value of the salvage value?
d) Calculate the tax shield and tax shield lost?
e) Compute the NPV on the project and whether to accept or reject the project?

Answer 1

		(a)	Initial Investment:
			New Equipment	$3,000,000
			Less:Salvage value of old equipment at time 0(today)	$600,000
			Net Initial Investment	$2,400,000
		X	Cash flow due to initial investment	($2,400,000)
			Note:Market research cost is sunk cost , hence , not considered
		(b)	RevisedCash Revenue	$11,000,000
			RevisedCash Expenses	$3,500,000
			Revised Cash inflow	$7,500,000
			Without investment:
			Cash Revenue	$8,000,000
			Cash expenses	$4,000,000
			Cash Inflow	$4,000,000
			Incremental Cash inflow per year (Before tax)	$3,500,000	(7500000-4000000)
			Incremental Cash inflow per year (After tax)	$2,450,000	(1-0.3)*3500000
			Life of project in years	6
			Doscount Rate=Cost of Capital=8%
		Y	Present Value of incremental After tax cash flow	$11,326,055	(Using PV function of excel with Rate=8%, Nper=6,Pmt=2450000
	.(C)	Z	Present Value of the Salvage value of new equipment	$            504,136	(800000/(1.08^6)
		.(d)
		N	Year	1	2	3	4	5	6
		A	Book Value of old equipment at Beginning of the year	$10,000,000	$8,000,000	$6,400,000	$5,120,000	$4,096,000	$3,276,800
		B=A*0.2	Depreciation	$2,000,000	$1,600,000	$1,280,000	$1,024,000	$819,200	$655,360
		C=B*0.3	Depreciation tax shield LOST (on Old Equipment)	$600,000	$480,000	$384,000	$307,200	$245,760	$196,608
		D	Book Value of New equipment at Beginning of the year	$3,000,000	$2,400,000	$1,920,000	$1,536,000	$1,228,800	$983,040
		E=D*0.2	Depreciation	$600,000	$480,000	$384,000	$307,200	$245,760	$196,608
		F=E*0.3	Depreciation tax shield (on New Equipment)	$180,000	$144,000	$115,200	$92,160	$73,728	$58,982
		G=F-C	Incremental Cash flow due to depreciation tax shield	($420,000)	($336,000)	($268,800)	($215,040)	($172,032)	($137,626)	SUM
		H=G/(1.08^N)	Present Value of Incremental depreciation tax shield	$          (388,889)	$ (288,066)	$      (213,382)	$     (158,061)	$    (117,082)	$     (86,727)	$ (1,252,207)
		I	Total incremental Cash flow due to depreciation tax shield	$      (1,252,207)
	.(e)	NPV=X+Y+Z+I	Net Present Value	$8,177,984
			Project should be accepted
			Because NPV is greater than zero