I need help with ALL parts of this question - a,b,c,d,e,f,g. I am having lots of

ID: 2777413 • Letter: I

Question

I need help with ALL parts of this question - a,b,c,d,e,f,g. I am having lots of difficulty solving and understanding what the question is asking. May someone please explain it using a step-by-step process that is not so vague, yet easy to understand and comprehend. Please provide the answers for a,b,c,d,e,f,g - also include any formulas that were used. I want to understand this question fully so that it will help me on future exams. Thanks so much in advance....

NOTE***** for the first part, do I ADD or SUBTRACT 50,000 from the initial outlay? I was confused, it says CHARGED but is that an outflow or inflow?

Question:

General Engine Corp. (GEC) has just finished minor renovations on their office building at a cost of $150,000. GEC originally allocated only $100,000 for this renovation. A memo from accounting suggests that the $50,000 cost overrun should be charged to the next new project the company will implement.

As its next project, General Engine Corp. is considering the acquisition of a new machine that would replace one of their old machines in use. The new machine costs $0.9 million (t=0), and it can be sold at the end of its expected 4-year operating life for $300,000. The new machine takes up more space and GEC will need to move maintenance and cleaning supplies that used to be stored next to the machine to a small storage room that could otherwise be sublet for $25,000 a year (at t=1 to t=4). The old machine was bought 8 years ago for $800,000 and can be sold for $300,000 today or for $150,000 in 4 years. GEC paid $25,000 for a study which indicates that the new machine will reduce manufacturing costs by $220,000 annually. Moreover, net working capital will be reduced by $150,000 when the new machine is installed, and will increase again by $150,000 at the end of the machine’s operating life. Both machines belong to asset class 43 with a CCA rate of 30%. GEC’s marginal tax rate is 40%, and it uses a discount rate (required rate of return, RRR) of 14% to evaluate projects of this nature.

a) What is the initial cash outlay (the total cash flow at t=0)?

b) What is the first year’s cash flow (excluding the CCA Tax Shield)?

c) What is the last year’s cash flow (excluding the CCA Tax Shield)?

d) What is the year 3 CCA?

e) What is the PV CCA Tax Shield?

f) What is the NPV of the replacement project?

g) Should General Engine Corp. replace the old machine with the new one?

Explanation / Answer

Answer (a)

Initial Cash Outlay = $ 525,000

Answer (b)

First Year’s Cash Flow (excluding CCA Tax Shield) = $ 117,000

Answer (c)

Last Year’s Cash Flow (excluding CCA Tax Shield) = $ 117,000

Answer (d)

Year 3 CCA = $ 132,300

Answer (e)

Present Value of CCA Tax Shield = $ 210,561.10

Answer (f)

Net Present Value = $ 115, 277.48

Answer (g)

As the NPV is positive, General Engine Corp. should replace the old machine with new machine.

working

Cost of New Machine = 0.9 * 1000000

$ 900,000

Add : Cost Overrun of previous project

$ 50,000

Add : Cost of Study undertaken

$ 25,000

Less : Salvage value of old machine

$300,000

Less : Reduction in Net Working Capital

$ 150,000

Initial Cash Outlay

$ 525,000

Discount Rate = 14%

Year 1

Year 2

Year 3

Year 4

Reduction in manufacturing costs

220,000

Less : Loss of subletting Income

25,000

Pre-tax Savings

195,000

Tax (at 40%)

78,000

Cash Flows excluding CCA Tax Shield

117,000

Discount Factor

1.14

1.2996

1.481544

1.68896016

Discounted Cash Flows

102,631.58

90,027.70

78,971.67

69,273.39

Total Present Value of Discounted Cash Flows (excluding CCA Tax Shield) = $ 340,904.34

Let I = initial investment = cost of new machine = $ 900,000 and

d = CCA rate = 30% or 0.30

Capital Cost Allowance (CCA) can be calculated using the below formula

Year

CCA formula

CCA Calculation

CCA amount

I * d

900,000 * 0.30

$ 270,000

I*d*(1-d)

900,000 * 0.30*(1-0.30)

$ 189,000

I*d*(1-d)^2

900,000 * 0.30*(1-0.30)^2

$ 132,300

I*d*(1-d)^3

900,000 * 0.30*(1-0.30)^3

$ 92,610

Year 3 CCA = $ 132,300

Marginal Tax Rate T= 40% or 0.40

Discount rate r = 14% or 0.14

Year

CCA amount

Tax Shield on CCA = CCA* T

Discount Factor = 1/(1+r)^year

Present value of CCA tax Shield = Tax Shield /Discount Factor

$ 270,000

$ 108,000

1.14

$ 94,736.84

$ 189,000

$ 75,600

1.2996

$ 58,171.75

$ 132,300

$52,920

1.481544

$ 35,719.49

$ 92,610

$ 37,044

1.68896016

$ 21,933.02

Total

$ 210,561.10

Present Value of CCA Tax Shield = $ 210,561.10

Salvage Value of New Machine after 4 years = $ 300,000

Present Value of Salvage Value = $ 300,000 / 1.14^4 = $ 177,624.08

Increase in Net Working Capital at the end of project = $ 150,000

Present Value of Net Increase in Working Capital = $ 150,000 / 1.14^4 = $ 88,812.04

NPV = - Initial investment + Present Value of cash flows excluding CCA Tax Shield + Present Value of CCA Tax Shield + Present Value of Salvage Value – Present Value of increase in working capital

NPV = -$ 525,000 + $ 340,904.34 + $ 210,561.10 + $ 177,624.08 - $ 88,812.04

NPV = $ 115,277.48