***PLEASE ANSWER ALL QUESTIONS***
You are a manager at Northern Fibre, which is considering expanding its operations in synthetic fibre manufacturing. Your boss comes into your office, drops a consultant's report on your desk, and complains, "We owe these consultants $1.8 million for this report, and I am not sure their analysis makes sense. Before we spend the $15 million on new equipment needed for this project, look it over and give me your opinion." You open the report and find the following estimates (in millions of dollars): 1 2 9 10 25.000 25.000 25.000 25.000 15.000 15.000 15.000 15.000 10.000 10.000 10.000 10.000 Sales revenue - Cost of goods sold = Gross profit - General, sales, and administrative expenses - Depreciation = Net operating income - Income tax 1.200 1.200 1.200 1.200 1.500 1.500 1.500 1.500 7.3000 7.3000 7.3000 7.3000 2.555 2.555 2.555 2.555 = Net income 4.745 4.745 4.745 4.745 All of the estimates in the report seem correct. You note that the consultants used straight-line depreciation for the new equipment that will be purchased today (year o), which is what the accounting department recommended for financial reporting purposes. CRA allows a CCA rate of 30% on the equipment for tax purposes. The report concludes that because the project will increase earnings by $4.745 million per year for ten years, the project is worth $47.45 million. You think back to your glory days in finance class and realize there is more work to be done! First you note that the consultants have not factored in the fact that the project will require $ 15 million in working capital up front (year 0), which will be fully recovered in year 10. Next you see they have attributed $1.2 million of selling, general and administrative expenses to the project, but you know that $0.6 million of this amount is overhead that will be incurred even if the project is not accepted. Finally, you know that accounting earnings are not the right thing to focus on! b. If the cost of capital for this project is 8%, what is your estimate of the value of the new project? Spherical Manufacturing recently spent $17 million to purchase some equipment used in the manufacture of disk drives. This equipment has a CCA rate of 30% and Spherical's marginal corporate tax rate is 36%. a. What are the annual CCA deductions associated with this equipment for the first five years? b. What are the annual CCA tax shields for the first five years? c. What is the present value of the first five CCA tax shields if the appropriate discount rate is 10% per year? d. What is the present value of all the CCA tax shields assuming the equiment is never sold and the appropriate discount rate is 10% per year? e. How might your answer to part (d) change if Spherical anticipates that its marginal corporate tax rate will increase substantially over the next five years? You are a manager at Northern Fibre, which is considering expanding its operations in synthetic fibre manufacturing. Your boss comes into your office, drops a consultant's report on your desk, and complains, "We owe these consultants $1.8 million for this report, and I am not sure their analysis makes sense. Before we spend the $15 million on new equipment needed for this project, look it over and give me your opinion." You open the report and find the following estimates (in millions of dollars): 1 2 9 10 25.000 25.000 25.000 25.000 15.000 15.000 15.000 15.000 10.000 10.000 10.000 10.000 Sales revenue - Cost of goods sold = Gross profit - General, sales, and administrative expenses - Depreciation = Net operating income - Income tax 1.200 1.200 1.200 1.200 1.500 1.500 1.500 1.500 7.3000 7.3000 7.3000 7.3000 2.555 2.555 2.555 2.555 = Net income 4.745 4.745 4.745 4.745 All of the estimates in the report seem correct. You note that the consultants used straight-line depreciation for the new equipment that will be purchased today (year o), which is what the accounting department recommended for financial reporting purposes. CRA allows a CCA rate of 30% on the equipment for tax purposes. The report concludes that because the project will increase earnings by $4.745 million per year for ten years, the project is worth $47.45 million. You think back to your glory days in finance class and realize there is more work to be done! First you note that the consultants have not factored in the fact that the project will require $ 15 million in working capital up front (year 0), which will be fully recovered in year 10. Next you see they have attributed $1.2 million of selling, general and administrative expenses to the project, but you know that $0.6 million of this amount is overhead that will be incurred even if the project is not accepted. Finally, you know that accounting earnings are not the right thing to focus on! b. If the cost of capital for this project is 8%, what is your estimate of the value of the new project? Spherical Manufacturing recently spent $17 million to purchase some equipment used in the manufacture of disk drives. This equipment has a CCA rate of 30% and Spherical's marginal corporate tax rate is 36%. a. What are the annual CCA deductions associated with this equipment for the first five years? b. What are the annual CCA tax shields for the first five years? c. What is the present value of the first five CCA tax shields if the appropriate discount rate is 10% per year? d. What is the present value of all the CCA tax shields assuming the equiment is never sold and the appropriate discount rate is 10% per year? e. How might your answer to part (d) change if Spherical anticipates that its marginal corporate tax rate will increase substantially over the next five years
