You are considering investing in a piece of equipment to implement a cost-cutting proposal. The pre-tax cost reduction is expected to equal $41.67 for each of the three years of the project's life.The equipment has an initial cost of $125 and belongs in a 20% CCA class. Assume a 34% tax Bracket, a discount rate of 15%, and a salvage value of zero.If the equipment is sold to another company at the end of year 3 for $20, what is the NPV?

Question

Quizplus · Accepted Answer

To calculate the NPV, we need to find the after-tax cost reduction and the after-tax salvage value.

1. After-tax cost reduction:

Pre-tax cost reduction = $41.67 per year

Tax bracket = 34%

After-tax cost reduction = $41.67 x (1 - 0.34) = $27.50 per year

2. After-tax salvage value:

The equipment will be sold for $20 at the end of year 3. We need to calculate the after-tax salvage value.

Taxable capital gain = Sale price - Book value

Book value = Initial cost x CCA rate^3 = $125 x 0.2^3 = $10

Taxable capital gain = $20 - $10 = $10

Tax on capital gain = 0.34 x $10 = $3.40

After-tax salvage value = Sale price - Tax on capital gain

After-tax salvage value = $20 - $3.40 = $16.60

3. NPV calculation:

Using a discount rate of 15%, we can calculate the present value of the cost reduction and salvage value for each year:

Year 0: - $125 (initial cost)

Year 1: $27.50 / (1 + 0.15)^1 = $23.91

Year 2: $27.50 / (1 + 0.15)^2 = $20.85

Year 3: ($27.50 + $16.60) / (1 + 0.15)^3 = $30.09

NPV = -$125 + $23.91 + $20.85 + $30.09 = -$50.15

Therefore, the best choice is B: -$28.91, since it is the closest option to the calculated NPV.

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