Suppose a six-year project requires an initial capital investment of $425,000 and an initial net working capital investment of $50,000.The project is expected to provide operating revenue of $270,000 per year.The associated operating costs are expected to be $130,000 per year.The capital asset belongs to Class 9 and has a CCA rate of 30%.The asset is expected to sell for $40,000 when the project terminates.Assume the asset class remains open when the asset is sold and the half-year rule applies in the first year.The firm's marginal tax rate is 40% and cost of capital is 8%.What impact would it have on the project's NPV if the cost of capital were 10%?

Question

Quizplus · Accepted Answer

First, we need to calculate the NPV at 8% cost of capital:
- Calculate the annual cash flow: operating revenue - operating costs - CCA tax shield
= $270,000 - $130,000 - (30% x ($425,000 + $50,000)) = $54,500
- Calculate the terminal cash flow: selling price + CCA tax shield
= $40,000 + (30% x $425,000) = $172,500
- Calculate the NPV:
= -$425,000 - $50,000 + Σ($54,500 / (1+0.08)^t) + ($172,500 / (1+0.08)^6)
= -$425,000 - $50,000 + $204,873.12 + $99,567.74
= -$170,559.14
Next, we calculate the NPV at 10% cost of capital:
- Calculate the annual cash flow: operating revenue - operating costs - CCA tax shield
= $270,000 - $130,000 - (30% x ($425,000 + $50,000)) = $54,500
- Calculate the terminal cash flow: selling price + CCA tax shield
= $40,000 + (30% x $425,000) = $172,500
- Calculate the NPV:
= -$425,000 - $50,000 + Σ($54,500 / (1+0.1)^t) + ($172,500 / (1+0.1)^6)
= -$425,000 - $50,000 + $189,745.64 + $83,264.87
= -$202,990.49
The change in NPV is:
= (-$202,990.49 + $170,559.14) / $170,559.14
= -0.3804
= -38.04%
Therefore, the NPV would decrease by 38.04% if the cost of capital were 10%. The answer is B.

Suppose a Six-Year Project Requires an Initial Capital Investment of $425,000