Question

RET Inc. currently has one product, low-priced stoves. RET Inc.  has decided to sell a new line of medium-priced stoves. Sales revenues for the new line of stoves are estimated at $50 million a year. Variable costs are 60% of sales.  The project is expected to last 10 years. Also, non-variable costs are $10,000,000 per year. The company has spent $4,000,000 in research and a marketing study that determined the company will lose (cannibalization) $10 million in sales a year of its existing low-priced stoves. The production variable cost of the existing low-priced stoves is $8 million a year.

The plant and equipment required for producing the new line of stoves costs $30,000,000 and will be depreciated down to zero over 30 years using straight-line depreciation. It is expected that the plant and equipment can be sold (salvage value) for $12,000,000 at the end of 10 years. The new stoves will also require today an increase in net working capital of $5,000,000 that will be returned at the end of the project.

The tax rate is 20 percent and the cost of capital is 10%.

1. What is the remaining book value for the plant at equipment at the end of the project?

2. What is the cash flow due to tax on salvage value for this project?

Answer 1

Cost of Plant and equipment = $ 30,000,000

Life of Plant and equipment = 30 years

Depreciation = Straight line

Depreciation per year = Cost of Plant and equipment / Life of Plant and equipment

= 30,000,000 / 30

= 1,000,000

Life of Project = 10 years

Total Depreciation in 10 years = Depreciation per year * 10

= 1,000,000 * 10

= $ 10,000,000

Book Value of Plant & Equipment at the end of the project = Cost of Plant and equipment - Total Depreciation in 10 years

= 30,000,000 - 10,000,000

= $ 20,000,000

Salvage Value of plant & equipment after 10 years = $ 12,000,000

Loss on Sale = Book Value - Salvage Value

= 20,000,000 - 12,000,000

= $ 8,000,000

Tax Shield on loss on sale of machinery = 8,000,000 * Tax rate

= 8,000,000 * 20%

= $ 1,600,000

After tax cash flow of plant and equipment = Loss on sale + tax shield

= 8,000,000 + 1,600,000

= $ 9,600,000