Question

Question 1: Evergreen company is investigating the feasibility of buying a new production line producing a new product. They project unit sales as in the below table, and they project price per unit to be $120 per unit at the beginning. And when competition catches up after 3 years (in the 4th year), they anticipate that the price would drop to $110. This project requires $20,000 in net working capital at the beginning. Subsequently, total net working capital at the end of each year would be about 15% of total sales for that year. The variable cost per unit is $60, and total fixed costs are $25,000 per year. It costs about $800,000 to buy the equipment necessary to begin production. This investment is primarily in industrial equipment and falls in Class 8 with a CCA rate of 20%. The equipment will actually be worth about $150,000 in eight years. The relevant tax rate is 40%, and the required return is 15%. Year Unit Sales 1 3000 2 5000 3 6000 4 6,500 5 6000 6 5000 7 4000 8 3000 Based on the above information: 1) Assuming that the asset class is closed calculate: a) NPV

Answer 1

1). If the asset class is closed then brute force technique is used, as follows:

CCA schedule:

Formula 0 1 3 4 5 6 7 8 2 576000 UCCn-1 - CCAN UCC 800000 720000 460800 368640 294912 235930 188744 150995 20%*UCCn-1; Half-year rule for Year 1 - 20%*400,000 CCA 80000 144000 115200 92160 73728 58982.4 47185.9 37748.7

NPV & IRR calculation:

Formula 0 1 2 3 4 5 6 7 3000 5000 5000 4000 3000 110 60 110 60 440000 Q*p Q*vc Year (n) Unit sales (0) Price per unit (p) Variable cost per unit (vc) Sales revenue (S) Total variable cost (TVC) Fixed cost (FC) |ССА |EBIT Tax @ 40% Net income (NI) Add: CCA Operating cash flow (OCF) 120 60 360000 180000 25000 80000 75000 30000 45000 80000 125000 1201 60 600000 300000 25000 144000 131000 6000 1201 601 720000 360000 25000 115200 219800 6500 1101 601 715000 390000 25000 92160 207840 6000 1101 60 660000 360000 25000 73728 201272 80509 120763 73728 194491 550000 300000 25000 58982 166018 66407 99611 58982 158593 240000 25000 47186 127814 51126) 110 601 330000 180000l 25000 377491 87251 34901 52351 37749 90099 S-TVC-FC-CCA 40%*EBIT EBIT-Tax 52400 87920 83136 76688 78600 144000 222600 131880 1152001 247080 124704 92160 216864 47186 123874 NI+CCA NWC 20000 54000 90000 108000 107250 99000 82500 66000 495001 15%*S NWCn-1-NWCn Return on total NWC in Year 8 Initial Investment Salvage value in Year 8 Change in NWC -20000 -34000 -36000 -18000 750 82501 16500 16500 66000 Capex -800000 150000 229080 91000 79130 186600 141096 217614 124422 202741 100798 175093 75698 140374 52772 3060991 100064 1506241 OCF+Change in NWC + Capex Free cash flow (FCF) FCF/(1+15%)^n PV of FCFS Sum of all PVs NPV Using IRR function with FCFS IRR -820000 -820000 4604 15.15%

2). If the asset class is open then instead of using CCA per year, PV of CCA tax shield is calculated and added to NPV directly.

NPV & IRR calculation:

Formula 0 1 2 3 4 5 6 7 6000 4000 3000 120 5000 120 6000 120 60 6500 110 60 110 5000 110 60 550000 300000 110 60 440000 Year (n) Unit sales(Q) Price per unit (p) Variable cost per unit (vc) Sales revenue (S) Total variable cost (TVC) Fixed cost (FC) EBIT Tax @ 40% Net income (NI) Q*p Q*vc 720000 360000 715000 390000 60 3600001 180000 25000 155000 62000 93000 60 600000 300000 25000 275000 110000 165000 8 3000 1101 601 3300001 180000 25000 125000 50000 25000 60 660000 360000 25000 2750001 110000 165000 25000 25000 240000 25000 175000 70000 S-TVC-FC 40%*EBIT EBIT-Tax 335000 134000l 201000 300000 120000 180000 225000 90000 135000 105000 75000 20000 54000 90000 108000 107250 99000 82500 660001 49500 -20000 -34000 -36000 - 18000 750 8250 16500 16500 66000 150000 15%*S NWC NWCn-1-NWCn Return on total NWC in Year 8 Change in NWC Initial Investment Salvage value in Year 8 Capex PV of CCA tax shield NI + Change in NWC + Capex + PV of CCA tax shield Free cash flow (FCF) FCF/(1+15%)^n PV of FCFs Sum of all PVs NPV Using IRR function with FCFS IRR -800000 159724 1515001 121500 -660276 -660276 59000 51304 129000 97543 183000 120325 180750 103344 173250 86136 291000 95128 65498 45676 4679 15.18%

PV of tax shield on CCA = [C*d*T*(1+0.5k)/(k+d)*(1+k)] - [S*d*T/((k+d)*(1+k)^n)] where

C (cost of equipment) = 800,000; d (CCA rate) = 20%; T (Tax rate) = 40%; k (cost of capital) = 15%; n (life of project) = 8; S (salvage value) = 150,000

PV of tax shield = [800,000*20%*40%*(1+0.5*15%)/(15%+20%)*(1+15%)] - [150,000*20%*40%/((15%+20%)*(1+15%)^8]

= 170,931.68 - 11,208.06 = 159,723.62