Delta Corporation is considering an investment of $400,000 in a new machine, whi

Question

Delta Corporation is considering an investment of $400,000 in a new machine, which belongs to asset class 43 with a CCA rate of 30 percent. The machine is not the only asset in the asset class. The fim's effective tax rate is 40 percent. The company has the following estimates: Project life Discount rate (k) Salvage value Annual after-tax operating cash flows $80,000$100.000 $60,000 Base Case Best Case Worst Case 8% $50,000 $60,000 $40,000 6 years 8 vears 4 years 10% 12% Based on the NPV of each scenario, would you recommend the company to undertake the project if each sce nario is equally likely?

Explanation / Answer

PV (CFATS) = $400, 000 *.4 *.3 ´ 1.05 - $50, 000 *.4 *.3 ´        1

= $106, 078.35

(.1+ .3)             1.10            (.1+ .3)            1.106

PV (CFAT ) = $80, 000 * PVAF (10%, 6) = $348, 420.86

PV (ECF ) = $50, 000 = $28, 223.70 1.106

NPV = -$400, 000 + $106, 078.35 + $348, 420.86 + $28, 223.70 = $82, 722.91

Best case scenario:

PV (CCATS ) = $400, 000 *.4 *.3 ´ 1.04 - $60, 000 *.4 *.3 ´         1

= $111, 400.75

(.08 + .3)            1.08          (.08 + .3)          1.088

PV (CFAT ) = $100, 000 * PVAF (8%,8) = $574, 663.89

PV (ECF ) = $60, 000 = $32, 416.13 1.088

NPV = -$400, 000 + $111, 400.75 + $574, 663.89 + $32, 416.13 = $318, 480.77

Worst case scenario:

PV (CCATS ) = $400, 000 *.4 *.3 ´ 1.06 - $40, 000 *.4 *.3 ´         1

= $100, 900.20

(.12 + .3)           1.12            (.1+ .3)            1.124

PV (CFAT ) = $60, 000 * PVAF (12%, 4) = $182, 240.96

PV (ECF ) = $40, 000 = $25, 420.72 1.124

NPV = -$400, 000 + $100, 900.20 + $182, 240.96 + $25, 420.72 = -$91, 438.12

B. The Expected NPV = $82, 722.91+ $318, 480.77 - $91, 438.12 = $103, 255.19

3

The base case NPV suggests that the project should be accepted because it generates a positive NPV. The best case NPV suggests that the project is very attractive and should be accepted. The worst case NPV suggests that the project is unattractive and should be rejected.

Examining these three scenarios reveals that the project is risky though it seems attractive and has significant upside, because it could turn out to be a losing proposition.

Given the project’s expected NPV is of a positive, large value, the project should be accepted.

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