Question

Sparkling Water Inc. (SWI) has just completed minor renovations to the CEOs office at a cost of $50,000. Originally, SWI planned to spend only $25,000 for this renovation. In a memo, the accounting group suggests allocating the cost over-run to the next project SWI will undertake.

As the next project, Sparkling Water Inc. is evaluating an investment in a new mineral water bottling plant. The required investment for the new bottling plant is $700,000 (at t = 0). The useful economic life of the plant is ten years. The salvage value of the plant in ten years is zero (at t = 10).

SWI hired PV Consultants for a market study. In their final report, the consultants estimate that SWI’s annual sales less expenses (before tax and not including depreciation) will increase from currently $350,000/year to $550,000/year (at t = 1 to t = 10). The consultants also estimate that net working capital will increase by $50,000 today (at t = 0) to meet increased demand and will be recaptured completely at the end of the project (at t = 10). The fee for this study amounts to $30,000 and SWI is required to pay this fee in one year (at t = 1)

The new mineral water bottling plant belongs to asset class 43 with a CCA rate of 30%. SWI will have other class 43 assets in ten years. SWI’s tax rate is 35% and it uses a required rate of return of 15% (EAR) to evaluate this project.

What is the CCA tax shield in year 2 (at t = 2)?

a) $51,450

b) $178,500

c) $62,475

d) $147,000 e) $111,475

What is the present value of CCA tax shields today (at t = 0)? a) $31,957

b) $152,681

c) $160,315
d) $163,587
e) $0, because the plant has a zero salvage value.

Suppose you find out that at the end of the project (at t = 10), to demolish the bottling plant and clean up the production site, SWI would incur additional before-tax clean-up costs of $25,000. By how much would the NPV of the project change based on this new information?
a) -$4,017

b) -$25,000
c) -$16,250
d) This information would not affect the NPV because it does not affect the project’s sales or expenses. e) The NPV would not change because the clean-up costs are sunk costs.

Suppose based on all the above information, SWI’s project team has calculated:

10∑t=0 CFt/ (1+RRR)^t =$67,480
CFt includes all project-relevant cash flows (including CCA tax shields). Based on this number, would you accept the project? Assume that for this project, a decision can be made using the IRR rule.
a) Yes, because the IRR > required rate of return (RRR).
b) No, because the IRR > required rate of return (RRR).

c) Yes, because the NPV = 0.
d) Yes, because the NPV < 0.
e) No, because the project’s payback period is greater than the project’s life (i.e., 10 years).

Answer 1

Solution:

CCA tax shield in year 2 (at t = 2)?

The answer is c) $62,475. Explation provided below:

Cost of the bottling plant is $700,000 at t=0. CCA is 30%; so first year depreciation will be $700000 * 0.3 * 0.5 = $105,000 since only 50% depreciation can be claimed. Second year t=2 depreciation is (700,000 - 105,000)*0.3 = $178,500

Tax rate is 35%

Hence, tax shield from CCA is $178,000 * 0.35 = $62,475.

Annual sales less expenses (before tax and not including depreciation) is $550,000/year. So same would apply to t=2. Cost over run is $ (50,000 - 25,000) = $ 25,000 which is to be allocated over the life of the bottling project. So $25,000 /10 years = $2,500. Same applies to t=2

Present value of CCA tax shields today (at t = 0)?

The solution is b) $152,681 as it is closest to our calculation done below:

Year	1	2	3	4	5	6	7	8	9	10
CCA deduction **	-105000	-178500	-124950	-87465	-61225.5	-42857.9	-30000.5	-21000.3	-14700.2	-10290.2
Tax shield @ 35%	-36750	-62475	-43732.5	-30612.8	-21428.9	-15000.2	-10500.2	-7350.12	-5145.08	-3601.56
Discount factors (1/1.15^n)	0.87	0.756	0.658	0.572	0.497	0.432	0.376	0.327	0.284	0.247
Tax shield * Discount rate	-31972.5	-47231.1	-28776	-17510.5	-10650.2	-6480.11	-3948.07	-2403.49	-1461.2	-889.585
Total of all the above present values (in the last row above)										-151323
** CCA deduction for t=1 & 2 calculated above for rest it is 30% of balance of $ 700,000 after previous deductions

Hence present value of CCA tax shield is $152,681

By how much would the NPV of the project change based on additional before tax clean up cost of $25,000 at t=10?

The answer is a) -$4,017. Explation provided below

Cash flows in t=10 without the additional before tax clean up cost of $25,000 would be:

a) Net income of $550,000

b) Recovery of working capital of $50,000

c) Amortization of cost over run of renovations to the CEOs office of (-) $2,500 (Non cash flow expense)

d) CCA deduction of (-) $10,290.20 according to our calculation in the previous answer. (Non cash flow expense)

So the net income by adding all the above values would be $587,209.80. Tax shield is $587,209.80* (-)0.35 = (-) $ 205,523.43 and Net income after tax $ 381,686.37. Add back CCA deduction & cost over run amortization as these are not cash flows to get pure cash inflow of $381686.37 + $10290.2 + $2500 = $394,476.57. Present value by multiplying discount factor 0.247 * $394,476.57 = $ 97,435.71

Had the clean up cost be considered the net income by adding all the above values would be $587,209.80 - $ 25,000 = $562,209.80. Tax shield is $562,209.80* (-)0.35 = (-) $ 196,773.43 and Net income after tax $ 365,436.37. Add back CCA deduction & cost over run amortization as these are not cash flows to get pure cash inflow of $365,436.37 + $10290.2 + $2500 = $378,226.57. Present value by multiplying discount factor 0.247 * $378,226.57 = $ 93421.96

Difference between the above two present values would be the difference in the NPV. So,  $ 97,435.71 - $ 93421.96 = 4013.75 which is the closest answer.

Based on 10∑t=0 CFt/ (1+RRR)^t =$67,480, would you accept the project?

The answer is a) Yes, because the IRR > required rate of return (RRR).

The required rate of return (RRR) is 15%. The above formula denotes that SWI's project team has calculated the NPV applying RRR = 15% and NPV is positive implying that the present value of all net cash flows is positive. This means that if we discount the net cash flows gradually by increasing the required rates of return above 15%, the net cash flows would be discounted more heavily bringing down $ 67,480 to 0 at some point. The rate that discounts the net cash flows or NPV to 0 is the Internal Rate of Return (IRR) of the project. Thus the reason for accepting the project assume that for this project, a decision can be made using the IRR rule is that the IRR would be greater than RRR.  The project generates higher return at the IRR than 15% expected of it.