A textile company invests $12 million in an open-end spinning machine.The machine belongs to asset class 43 and has a capital cost allowance (CCA)rate of 30%.It is expected that the new machine will increase revenues by $9 million per year with production and support costs of $0.5 million per year.If the company sold it immediately after the end of year 3 for $8 million,what would be the net present value (NPV)of owning the asset,given a tax rate of 40%,and a cost of capital of 12%?

Question

Quizplus · Accepted Answer

Step 1: Calculate the annual CCA for the machine

CCA = $12,000,000 × 30% = $3,600,000 per year

Step 2: Calculate the before-tax cash flow for each year

Year 0: -$12,000,000 (initial investment) 
Year 1: $9,000,000 - $3,600,000 - $0.5 million = $4,900,000 
Year 2: $9,000,000 - $3,600,000 - $0.5 million = $4,900,000 
Year 3: $9,000,000 - $3,600,000 - $0.5 million = $4,900,000 + $8,000,000 (machine sale price) 
= $12,900,000

Step 3: Calculate the after-tax cash flow for each year

Year 0: -$12,000,000 
Year 1: ($4,900,000 - $3,600,000) × (1 - 0.4) - $0.5 million = $847,000 
Year 2: ($4,900,000 - $3,600,000) × (1 - 0.4) - $0.5 million = $847,000 
Year 3: ($12,900,000 - $3,600,000 × (1 - 0.4) - $0.5 million) × (1 - 0.4) = $6,276,000

Step 4: Calculate the present value of each after-tax cash flow

Year 0: -$12,000,000 ÷ (1 + 0.12)^0 = -$12,000,000 
Year 1: $847,000 ÷ (1 + 0.12)^1 = $757,589 
Year 2: $847,000 ÷ (1 + 0.12)^2 = $677,374 
Year 3: $6,276,000 ÷ (1 + 0.12)^3 = $4,190,590

Step 5: Calculate the net present value (NPV)

NPV = ($757,589 + $677,374 + $4,190,590) - $12,000,000 = $7,561,553

Therefore, the best choice is A, with an NPV of $7,561,553.

A Textile Company Invests $12 Million in an Open-End Spinning