Corporate Finance

Week 3
Slide Solutions

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2020-07-16
Corporate Finance Week 3 — Slide Solutions

WEEK 3 — SLIDE SOLUTIONS

Solution to Slides 12 and 13, Capital budgeting: Cash flows — Exercise 1

1. Initial investment
• Building $2,500,000
• Machine plus installation 850,000
• Land: 750,000 – [0.32 × ½ × (750,000 – 400,000)] 694,000
• Working capital 300,000

2. Salvage (at the end of Year 8)

• Building $625,000
• Machine 85,000
• Land: 900,000 – [0.32 × ½ × (900,000 – 750,000)] 876,000
• Working capital 300,000

3. Operations
• Annual after-tax incremental revenues: (1 – 0.32) × 200,000 × $15 $2,040,000
• Annual costs: (1 – 0.32) × 200,000 × $8 1,088,000
• CCA tax shield — building and machine

Solution to Slide 23, CCA tax shield — Exercise 2a

Net acquisition = (150,000 + 25,000) – 35,000 = $140,000

Year 1: CCA = 140,000 × 1.50 × 0.20 = $42,000

CCA tax shield = 42,000 × 0.30 = $12,600

Year 2: CCA = (140,000 – 42,000) × 0.20 = $19,600

CCA tax shield = 19,600 × 0.30 = $5,880

Year 3: CCA = (140,000 – 42,000 – 19,600) × 0.20 = $15,680

CCA tax shield = 15,680 × 0.30 = $4,704

Manor will enjoy a tax shield (reduced taxes payable) from the CCA deduction of
$12,600 in Year 1, $5,880 in Year 2, and $4,704 in Year 3.

At the end of Year 3, the remaining UCC balance related to this machine is $62,720
(= 140,000 – 42,000 – 19,600 – 15,680), and the new model will then be sold for
$28,000.

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Corporate Finance Week 3 — Slide Solutions

At the time of the sale, the UCC balance will be reduced by $28,000. As Manor will
continue to have assets in the same pool, the residual UCC will remain eligible for CCA
into the future. Assuming the asset class pool remains open, Manor can continue to
benefit from a CCA tax shield on the asset indefinitely.

Solution to Slide 24, CCA tax shield — Exercise 2b

Net acquisition = (150,000 + 25,000) – 35,000 = $140,000

Year 1: CCA = 140,000 × 100% = $140,000

CCA tax shield = 140,000 × 0.30 = $42,000

Year 2: CCA = (140,000 – 140,000) × 0.50 = $0

CCA tax shield = $0

Year 3: CCA = $0
CCA tax shield = $0

Manor will enjoy a tax shield (reduced taxes payable) from the CCA deduction of
$42,000 in Year 1 and $0 thereafter.

At the end of Year 3, the remaining UCC balance is $0.

At the time of the sale, the UCC balance will be reduced by $28,000. As Manor will
continue to have assets in the same pool, the remaining UCC will still be eligible for
CCA into the future. Because the asset class pool remains open, and assuming the
UCC balance prior to the sale is at least $28,000, Manor will avoid recapture on the
sale.

Solution to Slide 27, PVCCA tax shield — Exercise 3

140,000(0.20)(0.30) 1+(1.5 ×0.08)
a) = × = $31,111
0.20+0.08 1+0.08

This PVCCA tax shield figure of $31,111 represents the present value of the total
CCA tax shield that Manor would benefit from if it doesn’t dispose of the machine at
the end of its useful life (three years).

If Manor sells the machine at the end of Year 3, the UCC balance will be reduced by
the proceeds, and the ongoing CCA tax shield will be reduced accordingly.

b) = ($140,000 × 100% × 30%) / (1.08) = $38,889

This PVCCA tax shield figure of $38,889 represents the present value of the total
CCA tax shield that Manor would benefit from if it doesn’t dispose of the machine at
the end of its useful life (three years).

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Corporate Finance Week 3 — Slide Solutions

If Manor sells the machine at the end of Year 3, the UCC balance will be reduced by
the proceeds, and the ongoing CCA tax shield will be reduced accordingly.

Solution to Slide 30, PVCCA tax shield lost — Exercise 4

a) PVCCA tax shield lost: [(28,000)(0.20)(0.30)]/(0.20 + 0.08) × 1/(1 + 0.08)3 = $4,763

b) Taxes on salvage: 28,000 × 30% = $8,400

Present value of taxes on salvage = $8,400/1.083 = $6,668

Solution to Slide 31, PVCCA tax shield and PVCCA tax shield lost — Exercise 5

Building:
2,500,000(0.04)(0.32) 1.21
PVCCA tax shield = × = $188,694
0.04 + 0.14 1.14

625,000(0.04)(0.32) 1
PVCCA tax shield lost = × = $15,580
0.04 + 0.14 (1.14)8

Machine:
850,000(0.20)(0.32) 1.21
PVCCA tax shield = × = $169,825
0.20 + 0.14 1.14

85,000(0.20)(0.32) 1
PVCCA tax shield lost = × = $5,609
0.20 + 0.14 (1.14)8

Solution to Slides 33 to 35, Capital budgeting: NPV — Exercise 6

1. Initial investments
Facility $1,500,000
Equipment 200,000
Land: 250,000 – [0.37 × ½ × (250,000 – 200,000)] 240,750
Working capital 50,000
$1,990,750

2. Salvage — proceeds (at the end of Year 6)

Facility $ 750,000
Equipment 25,000
Land: 300,000 – [0.37 × ½ × (300,000 – 250,000)] 290,750
Working capital 50,000
$1,115,750

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Corporate Finance Week 3 — Slide Solutions

3. Annual incremental after-tax operating income

Annual net revenues: (1 – 0.37) × $500,000 $315,000
Lost revenues annually: (1 – 0.37) × $100,000 (63,000)
Net annual incremental after-tax revenues $252,000

4. PVCCA tax shield and PVCCA tax shield lost

Facility:
1,500,000(0.06)(0.37) 1.165
PVCCA tax shield = × = $205,588
0.06 + 0.11 1.11

750,000(0.06)(0.37) 1
PVCCA tax shield lost = × = $52,363
0.06 + 0.11 (1.11)6

Equipment:
PVCCA tax shield = ($200,000 × 100% × 37%) / (1.11) = 66,667
25,000(0.50)(0.37) 1
PVCCA tax shield lost = × = $4,054
0.50 + 0.11 (1.11)6

Summary:
Initial investments: $(1,990,750)

Salvage: $1,115,750 / (1.11)6 596,526

Incremental revenue: 1,066,096

PMT = 252,000 I/Y = 11% N=6 CPT PV

PVCCA tax shield and PVCCA tax shield lost:

Facility: PVCCA tax shield 205,588
PVCCA tax shield lost (52,363)
Equipment: PVCCA tax shield 66,667
PVCCA tax shield lost (4,054)
NPV $(112,290)

As the NPV is negative, Eureka should not build the new facility.

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Corporate Finance Week 3 — Slide Solutions

Solution to Slide 40, Capital budgeting: Payback period — Exercise 7

For Project A
PBPA = 32,000 ÷ 4,500 = 7.1 years

For Project B
Year 1 Year 2 Year 3 Year 4 Year 5
Beginning investment balance $600,000 $500,000 $370,000 $215,000 $ 65,000
Less: annual cash flow 100,000 130,000 155,000 150,000 170,000
Remaining investment balance $500,000 $370,000 $215,000 $ 65,000 $(105,000)

Payback is achieved between Years 4 and 5.

PBPB = 4 + (65,000 ÷ 170,000) = 4.4 years

Solution to Slide 43, Capital budgeting: Internal rate of return — Exercise 8

–850,000 + 170,000 × PVAF (IRR%, 10) = 0

IRRC = 15.0984%

PMT = $170,000 N = 10 PV = –$850,000 CPT I/Y% = 15.0984%

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