Question

Bowie Workshop is thinking about buying a new piece of equipment.  They have collected the following pieces of information:

• The cost of the new equipment will be $1,100,000;
• The lifespan of the equipment is 4 years;
• Salary of the General Manager, who will oversee the new equipment in addition to his current responsibilities is $89,000 per year;
• 500 units are expected to be sold each year selling price per unit is $10,000;
• Variable costs per unit is $5,000;
• Fixed costs allocated to the new equipment will be $1,000,000 per year (610,000 of new costs and 390,000 of existing costs);
• Working Capital startup increase of $90K and 30% of sales each year afterwards;
• Expected rate of return is 20%;
• Tax Rate is 40%;
• Capital Cost Allowance (CCA) for the new equipment is 20%;
• Salvage value of the new equipment is expected to the Undepreciated Capital Costs (UCC) at the end of forth year.

Required: Comment on whether Bowie should invest in the new equipment based on NPV.

Steps:

1. Determine which costs should be used and where.
2. Calculate the Depreciation Schedule.
3. Calculate the Proforma Income Statement.
4. Project Future Cashflows.
5. Calculate NPV and Discounted Payback.

Answer 1

Determination of usage of costs

Type of Cost	Amount	Where to use
General Manager Salary	$89,000 p.a.	Relevant Cost
Variable Cost (500 units @ $5000)	$2,500,000 p.a.	Relevant Cost
Fixed cost allocable (only new cost)	$610,000 p.a.	Relevant Cost
Capital Cost Allowance (20% of $1,100,000)	$220,000 for 1st year	For tax calculations
Tax (@40%)

Depreciation Schedule

Depreciation Schedule shall be made only for the tax calculation purpose since the depreciation cost is a non-cash cost and hence is irrelevant for the decision making

Particulars	Life of Equipment
	Year 1	Year 2	Year 3	Year 4
Opening Cost (A)	$1,100,000	$880,000	$704,000	$563,200
Depreciation CCA (20% of A) (B)	$220,000	$176,000	$140,800	$112,640
Closing Cost (A-B)	$880,000	$704,000	$563,200	$450,560

Proforma Income Statement

Particulars	Year 1	Year 2	Year 3	Year 4
Expected Sales (Growth of 30%)	$5,000,000	$6,500,000	$8,450,000	$10,985,000
Relevant Variable Cost	($2,500,000)	($3,250,000)	($4,225,000)	($5,492,500)
Relevant Fixed Cost	($610,000)	($610,000)	($610,000)	($610,000)
Additional GM Salary	($89,000)	($89,000)	($89,000)	($89,000)
Allocable Depreciation ($1,100,000 / 4)	($275,000)	($275,000)	($275,000)	($275,000)
Income before tax	$1,526,000	$2,276,000	$3,251,000	$4,518,500

Projected Future Cash Flows

Particulars	Year 1	Year 2	Year 3	Year 4
Income before tax	$1,526,000	$2,276,000	$3,251,000	$4,518,500
Add : Allocable Depreciation	$275,000	$275,000	$275,000	$275,000
Cash Income	$1,801,000	$2,551,000	$3,526,000	$4,793,500
Less : Depreciation CCA (from depreciation schedule)	($220,000)	($176,000)	($140,800)	($112,640)
Profits before tax	$1,581,000	$2,375,000	$3,385,200	$4,680,860
Less : Tax @ 40%	($632,400)	($950,000)	($1,354,080)	($1,872,344)
Profits after tax	$948,600	$1,425,000	$2,031,120	$2,808,516
Add : Depreciation CCA	$220,000	$176,000	$140,800	$112,640
Cash Flows	$1,168,600	$1,601,000	$2,171,920	$2,921,156

Calculation of Net Present Value

Period	Particulars	Amount	Discounted Factor @ 20%	Present Value
0	Cost of Equipment	$    (1,100,000)	1	$ (1,100,000)
0	Working Capital	$          (90,000)	1	$        (90,000)
1	Cash Flows	$       1,168,600	0.8333	$        973,794
2	Cash Flows	$       1,601,000	0.6944	$    1,111,734
3	Cash Flows	$       2,171,920	0.5787	$    1,256,890
4	Cash Flows	$       2,921,156	0.4823	$    1,408,874
4	Salvage Value of Equipment	$          450,560	0.4823	$        217,305
4	Working Capital	$             90,000	0.4823	$          43,407
	Net Present Value			$    3,822,005

Since the NPV is positive it means that expected rate of return has achieved, hence the proposal of buying a new piece of equipment is viable.

Discounted Payback is the period within the overall investments have been returned back, since total NPV is about $3.8m hence the payback period is less than one year.