The managers of PonchoParts, Inc. plan to manufacture engine blocks for classic cars from the 1960s era. They expect to sell 250 blocks annually for the next ﬁve years. The necessary foundry
And machining equipment will cost a total of $800,000 and belongs in a 30% CCA class for tax
Purposes. The ﬁrm expects to be able to dispose of the manufacturing equipment for $150,000 at
The end of the project. Labour and materials costs total $500 per engine block, ﬁxed costs are
$125,000 per year. Assume a 35% tax rate and a 12% discount rate.
What is the present value of the CCA tax shield?

Question

Quizplus · Accepted Answer

1) Calculation of Annual Cash Flows:
Annual Revenue = 250 blocks x $2,500 (selling price) = $625,000
Variable Costs = $500 x 250 blocks = $125,000
Fixed Costs = $125,000
EBIT = $625,000 - $125,000 - $125,000 = $375,000
Taxes = 0.35 x $375,000 = $131,250
Net Income = $375,000 - $131,250 = $243,750
Depreciation = $266,667/5 = $53,333
Annual Operating Cash Flow = $243,750 + $53,333 = $297,083

2) Calculation of Tax Shield:
CCA Tax Shield = (Initial Cost of Equipment x CCA Rate) x Tax Rate
= ($800,000 x 0.30) x 0.35
= $84,000

3) Calculation of Terminal Cash Flow:
Sale of Equipment = $150,000
Tax on Salvage Value = (Salvage Value - Book Value) x Tax Rate
= ($150,000 - $240,000) x 0.35
= -$24,000
Terminal Cash Flow = $150,000 - $24,000 = $126,000

4) Calculation of Present Value of Cash Flows:
PV(CCA Tax Shield) = $84,000 x (1 - 1/(1 + 0.12)^5)/0.12
= $336,576.77
PV(Annual Operating Cash Flows) = $297,083 x (1 - 1/(1 + 0.12)^5)/0.12
= $1,129,008.05
PV(Terminal Cash Flow) = $126,000/(1 + 0.12)^5
= $67,256.77
Total Present Value = $1,532,841.59

Therefore, the best choice is to invest in the project as the total present value of cash flows exceeds the initial cost of the project.

The Managers of PonchoParts, Inc