In Class Questions

Estimating Cash Flows and Replacement Projects

1.Venture Tech. Inc. has just completed market research on a new smartphone at the cost of $350,000. This new phone is lighter and smaller, though more feature rich, than its existing product. New product sales are estimated at 1,000,000 units per year with a contribution margin of $40. However, if Venture Tech. introduces its new product, sales of its existing smartphone will fall from 600,000 to 250,000 units per year. Its existing product has a contribution margin of $30.

The company will retool one of its existing manufacturing facilities to produce the new model. The one-time retooling cost is $3,700,000. There will also be $80,000 in retraining costs incurred for workers who lost their jobs manufacturing the existing product. The new facility is expected to increase fixed cash costs of $150,000 per year. Research and development on the new phone took two years at a cost of $1,900,000. The R&D group also paid an external company for use of their advanced testing facilities at a further cost of $100,000.

Venture Tech has also spent $90,000 in the design of a new corporate headquarters. Building the headquarters will cost $4,000,000.

For capital budgeting purposes, calculate the project's:

a.Initial cost

b.Annual cash flows before tax

2.Ever Sparkle Company is considering an average-risk investment in a mineral water spring project that has a cost of $150,000. The project will produce 1,000 cases of mineral water per year indefinitely. The current sales price is $138 per case, and the current cost per case (all variable) is $105. The firm is taxed at a rate of 34%. Both prices and costs are expected to ruse at a rate of 6% per year. The firm uses only equity, and it has a cost of capital of 15%. Assume that cash flows consist only of after-tax profits, since the spring has an indefinite life and will not be depreciated.

a.Should the firm accept the project?

b.If total costs consisted of a fix cost of $10,000 and variable costs of $95 per unit, and if only the variable costs were expected to increase with inflation, would this make the project better or worse? Continue with the assumption that the sales price will rise with inflation.

3.Green Day Packers (GDP) purchased a computer for its back office operations in 2008 (Class 45, 45% CCA) for $5,000. Because of expanding operations, GDP purchased two additional computers in 2010 for $4,000 each. By 2011, the original computer was considered to be too slow and was sold for $800. One year later the company decided to sell all its computer hardware for $1,500 and outsource its operations. Calculate GDP's UCC and maximum CCA for each year, from 2009 to 2012. Assume that the asset class is closed upon sale of the computers. If GDP's income is $50,000 before claiming CCA for 2012 and its tax rate is 30%, how much tax will the company have to pay?

4.Central Drug Mart (CDM) is a drugstore chain operating in Ontario and Quebec. The company is contemplating a home delivery service for its prescription drug sales to customers who are unable to pick up their drugs in the stores. CDM is investigating whether to invest in small hybrid automobiles. The new delivery service is forecast to increase prescription drug sales by $550,000 per year. CDM's total variable costs are 60% of sales (a contribution margin of 40%). CDM will also charge a nominal delivery fee of $3 per delivery.

The new hybrid fleet would cost $950,000 and would have an economic life of 7 years, after which the salvage value would be $50,000. The company expects to make 10,000 deliveries per year.

On further investigation, CDM finds that the new vehicles would save $60,000 per year in fuel costs compared to regular gasoline-powered vehicles. Spare parts inventory of $30,000 would have to be purchased. Assume that the spare parts inventory is purchased at t=0.

CDM typically uses a 12% cost of capital. Its tax rate is 35%, and the vehicles fall into a CCA class of 30%.

a.What is the NPV of this fleet delivery project?

b.What is the PV of CCA tax shield for the vehicles?

c.If the federal government changed the CCA rate to 50% for hybrid vehicles to encourage their use, what would the NPV of the project now be?