Foundations of Financial Management

Block, Hirt, Danielson and Short: $12$ce

Practice for Test $2$

Part $2$ Question $2$

$1.$ Great Corporation, located in the GTA, purchased a radio communication system three years ago for $$385,000.$ It has a potential buyer for the system that is willing to pay $$105,000.$ A new system will cost $$450,000$ and is eligible for a $20$ percent ITC.

It is estimated the new system would provide the following stream of cost savings over the next five years:

Year Cost Savings

$1$ $$119,000$

$292,000$

$378,000$

$470,000$

$560,000$

The tax rate is $30$ percent, and the estimated cost of capital is $12$ percent. Should the new system be purchased?

Gather the key facts and answer the questions above

Solution

Practice for Test $2$

Key Facts

Initial Investment $$450,000$ wrong

CCA Rate $($d$)$ wrong

Tax rate $($t$)$ wrong

Cost of capital $($r$)$ wrong

ITC rate wrong

Number of Years wrong

Old Equipment Salvage wrong

Year Annual Cash Flow

$1$ wrong

$2$ wrong

$3$ wrong

$4$ wrong

$5$ wrong

Question a: NPV Calculation

Year Items Expected Cash Flow After tax Cash flow Present Value of Cash flow

$0$ Initial Investment wrong wrong wrong

$0$ Trade in of Old Equipment wrong wrong wrong

$1$ ITC wrong wrong wrong

$1$ Cost savings wrong wrong wrong

$2$ Cost savings wrong wrong wrong

$3$ Cost savings wrong wrong wrong

$4$ Cost savings wrong wrong wrong

$5$ Cost savings wrong wrong wrong

Calculating CCA Tax Shield

$($C$-$S$)$ wrong

dt wrong

$($r$+$d$)$ wrong

dt$/($r$+$d$)$ wrong

$(1+0\mathrm{.}5$r$)/(1+$r$)$ wrong

$-$ITC x $($dt$/$r$+$d$)$ x $1/(1+$r$)^1$ wrong

$0$ PV of CCA Tax shield wrong

NPV wrong

Decision wrong