5) DogChew Products needs to replace its rawhide tanning and molding equipment.
ID: 2578134 • Letter: 5
Question
5) DogChew Products needs to replace its rawhide tanning and molding equipment. They have undergone a capital budgeting NPV analysis and have determined they should accept the project. You have been provided with the following information i. The equipment has a purchase price of $930,000 and has a seven-year useful life ii. iii. iv. The estimated salvage value is $95,000 in seven years The project will generate after-tax cash flows of $200,000 per year. If they lease the equipment from RayNot Financing, the lease payments will be $205,000 per year for 7 years with the payments made at the beginning of the year. If the asset is purchased, Dog Chew Products will be responsible for maintenance costs of $55,000 per year; if leased, the lessee will be responsible for maintenance costs Maintenance costs are paid at the end of the year. If the asset is leased, additional insurance of $10,000 per year will be required which the lessee is responsible for. This must be paid at the beginning of each year. The asset belongs in an asset class with a CCA rate of 20% Dog Chew Products has a marginal tax rate of 35%. The before-tax cost of debt is 9% The lease qualifies as a true tax lease for tax purposes v. vi. vii. viii. a) Should Dog Chew Products buy or lease the equipment? Show all your work. (32 marks) b) How would your answer to part (a) change if the lessor was responsible for the annual maintenance costs? Show your work. (8 marks)Explanation / Answer
Leasing of Asset
Particulars
Amount (In $)
(A)
Time(n)
Present Value Factor (1/ (1.0585)n), i=9%(1-0.35)
(B)
Present Value Amount (In $)
(A x B)
Cash Outflows:
Lease Payments net of tax
205,000 (1-0.35) = 133,250
0
1
133,250
Lease Payments net of tax
133,250
1-6
4.94
658,255
Maintenance cost net of tax
55,000 (1-0.35) = 35,750
1-7
5.612
200,629
Insurance net of tax
10,000 (1-0.35) = 6,500
0-6
5.94
38,610
TOTAL PRESENT VALUE OF CASH OUTFLOWS
1,030,744
Cash Inflows:
After tax cash flows
200,000
1-7
5.612
1,122,400
Present Value of Cash flows
91,656
Purchase of Asset
Particulars
Amount (In $)
(A)
Time(n)
Present Value Factor (1/ (1.0585)n), i=9%(1-0.35)
(B)
Present Value Amount (In $)
(A x B)
Cash Outflows:
Purchase price
930,000
0
1
930,000
Maintenance cost net of tax
55,000 (1-0.35) = 35,750
1-7
5.612
200,629
TOTAL PRESENT VALUE OF CASH OUTFLOWS
1,130,629
Cash Inflows:
After tax cash flows
200,000
1-7
5.612
1,122,400
Tax Savings on Depreciation year 1 for half year
93,000 x 35%
1
0.944
30,727
Tax Savings on Depreciation year 2
167,400 x 35%
2
0.892
52,262
Tax Savings on Depreciation year 3
133,920 x 35%
3
0.843
39,513
Tax Savings on Depreciation year 4
107,136 x 35%
4
0.796
29,848
Tax Savings on Depreciation year 5
85,708.8 x 35%
5
0.752
22,559
Tax Savings on Depreciation year 6
68,567 x 35%
6
0.711
17,062.90
Tax Savings on Depreciation year 7
54,854 x 35%
7
0.672
12,901
Sale of Machine net of gain tax
95,000
7
0.672
63,840
TOTAL Cash Inflows
1,391,112
Present Value of Cash flows
260,483
NOTE 1:
Opening Balance
Rate of Depreciation
Depreciation for year under reducing Balance
Closing Balance of Depreciation
930,000
20%
930,000 x 20% / 2 = 93,000
837,000
837,000
20%
837,000 x 20% = 167,400
669,600
669,600
20%
669,600 x 20% = 133,920
535,680
535,680
20%
535,680 x 20% = 107,136
428,544
428,544
20%
428,544 x 20% = 85,708.8
342,835.2
342,835
20%
342,835 x 20% = 68,567
274,268
274268
20%
274,268 x 20% = 54,854
219,414
NOTE: Half year rule is applied to the asset for first year.
NOTE2: Calculation of Capital Gain
Book Value as per income tax at end of 7 years = $219,414
Salvage Value = $95,000
Gain on sale of asset = $0
Tax on sale of asset = $0
IN THE GIVEN CASE, ASSET SHOULD BE PURCHASED AS PRESENT VALUE OF CASH INFLOWS IS MORE IN THAT CASE.
Particulars
Amount (In $)
(A)
Time(n)
Present Value Factor (1/ (1.0585)n), i=9%(1-0.35)
(B)
Present Value Amount (In $)
(A x B)
Cash Outflows:
Lease Payments net of tax
205,000 (1-0.35) = 133,250
0
1
133,250
Lease Payments net of tax
133,250
1-6
4.94
658,255
Maintenance cost net of tax
55,000 (1-0.35) = 35,750
1-7
5.612
200,629
Insurance net of tax
10,000 (1-0.35) = 6,500
0-6
5.94
38,610
TOTAL PRESENT VALUE OF CASH OUTFLOWS
1,030,744
Cash Inflows:
After tax cash flows
200,000
1-7
5.612
1,122,400
Present Value of Cash flows
91,656
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