Practice Problem

Fast Motor Company

Discounted cash flow analysis using the tax shield ap

Purpose: To evaluate the expansion proposal using the NPV approach.

in millions of dollars Inception

Initial investment
Capital expenditures — building $ (1,500)
Capital expenditures — equipment (1,750)
Consultant cost -
Land — net after-tax proceeds on sale (103)
Tax shield — building 1,500 10% 206
Tax shield — equipment 1,750 100% 401

Annual operating after-tax cash flows

Sales
Variable operating costs
Fixed operating costs
Side effects — lost cash flows from other divisions

Income tax thereon 25%

After-tax annual operating cash flows

Investment in working capital (100)

Salvage values
Salvage value Land
Salvage value — building
Lost tax shield on building
Salvage value — equipment
Lost tax shield on equipment

Net incremental cash flow (2,846)

PV factor — discount rate is 9% (mid-year except end of year 2027) 9% 1.0000

Net present value $ 517 $ (2,846)

Conclusion: The proposal generates a positive net present value and is expected to increase organizational value

Assumptions:

1) The project will last for six years.

2) The annual cash flow will be impacted by inflation assumed to be 2%.

Notes: $s are in millions

 Practice Problem

Note 1: Per expansion plan proposal, $1,500 will be spent at inception for the building and $1,750 will be spent for equipment.
Note that the consultant cost is a sunk cost and is not included in this analysis.

Note 2: The land is a lost opportunity cost and has to be included in the initial investment costs. The opportunity cost is after ta
The calculation of the opportunity cost is:
Proceeds on sale 114
Less taxes on taxable capital gain (11)
103

Note 3: Tax shield formula = [Investment cost × CCA rate × 25% × (1 + 9% / 2)] / [(CCA + 9%) × (1 + 9%)]
Equipment = [($1,750 × 25%) / (1 + 9%)]
Building = [$1,500 × 10% × 25% × (1 + 9% × 1.5)] / [(10% + 9%) × (1 + 9%)

Note 4: To determine the annual sales forecast, use the number of units sold × unit price each year.

Unit sales
Unit price per car
Annual sales in millions of dollars

Note 5: Variable costs are 38% of sales as given.

Note 6: Fixed costs increase with inflation at 2% each year.

Note 7: Side effects — The lost sales from other divisions is a side effect that needs to be included in the cash outflows related

Note 8: The company is taxed at a rate of 25% as stated in the case.

Note 9: Calculation of changes in net working capital

Working capital starts at $100 and then is equal to 15% of the next year's sales

Inception
Net working capital closing balance 100
Opening balance -
Change in working capital balance -

Note 10: At the end of the six years, the land will be sold for $260. Note that this amount is already after sales commission cos

Note 11: The building and equipment will be sold at the end of the project's life. The lost tax shield is calculated below. This ass
Tax shield formula for assets sold
Lost tax shield — building ($800 × 10% × 25%) / (10% + 9%) =
Lost tax shield — equipment ($400 × 50% × 25%) / (50% + 9%) =
 Practice Problem

st Motor Company
nalysis using the tax shield approach

2022 2023 2024 2025 2026 2027

$ 540 $ 1,377 $ 3,043 $ 3,104 $ 3,166 $ 3,229

(205) (523) (1,156) (1,180) (1,203) (1,227)
(560) (571) (582) (594) (606) (618)
(125) (100) (75) (50) (25) -
(350) 183 1,230 1,280 1,332 1,384
88 (46) (308) (320) (333) (346)
(262) 137 922 960 999 1,038

(107) (249) (10) (9) (9) 484

(369) (112) 912 951 990 1,522

0.9578 0.8787 0.8062 0.7396 0.6785 0.6225

$ (353) $ (98) $ 735 $ 703 $ 672 $ 947

d to increase organizational value.

 Practice Problem

,750 will be spent for equipment.

is analysis.

ts. The opportunity cost is after tax.

= $120 × (1 – 5%)
= (114 – 30) × 50% × 25%

) × (1 + 9%)]

× 1.5)] / [(10% + 9%) × (1 + 9%)]

2022 2023 2024 2025 2026 2027

12,000 30,000 65,000 65,000 65,000 65,000
$ 45,000 $ 45,900 $ 46,818 $ 47,754 $ 48,709 $ 49,683
$ 540 $ 1,377 $ 3,043 $ 3,104 $ 3,166 $ 3,229

luded in the cash outflows related to this project because it is a directly related incremental cash flow.

year's sales

2022 2023 2024 2025 2026 2027

207 456 466 475 484 -
100 207 456 466 475 484
107 249 10 9 9 (484)

ready after sales commission costs and income taxes.

hield is calculated below. This assumes that there are still other assets in the class.

105
85
 Practice Problem

End of project
2027

Note 1
Note 1
Note 1 — This is a sunk cost.
Note 2
Note 3
Note 3

Note 4
Note 5
Note 6
Note 7

Note 8

Note 9

260 Note 10
800 Given
(105) Note 11
400 Given
(85) Note 11

1,270

0.5963

$ 757
 Practice Problem

= Sales for the next year × 15%