COURSE UPDATE
PA1: Issues in Professional Practice
Spring Session 3 Module 1 Self-Test Case
NPV calculation
For distribution to course directors, lecturers,
markers, tutors and students
Module 1 Self-Test Case - NPV calculation
The NPV calculation in the self-test case solution should read as follows (deletions crossed out,
changes in bold):
Analysis of the new machine for your business
You can invest the $500,000 in your corporation as new equity or as a shareholder loan. The $500,000
investment in your business will yield annual cash flows of $70,000 (depreciation is not a cash
outflow). Your cost of capital is expected to be 7% (the same as the current bank loan rate).
The common measures used for analyzing investments in new projects include net present value
(NPV), internal rate of return (IRR), and payback period. Such investment analysis is normally based
on four inputs:




A one-time net investment (-CF0)
Benefits realized in the form of future operating income or cash flows. EBITDA Aftertax earnings serves as a good proxy for cash flows in investment analysis [E(CFi)]
Estimated time period between year of investment and year of benefits (n)
Firm’s cost of capital (ki)
We will only consider NPV because this is the only method that takes into account the time value of
money and all relevant cash flows. Exhibit 1 shows the calculations for the NPV, which is ($52,910)
-$151,269.
However, we must take into account the benefits from the tax shield. The calculation of the present
value of tax savings from depreciation (CCA) tax shelters over the (perpetual) life of an asset is
$86,273, as shown in Exhibit 2.
The tax savings are reduced by a further $5,191, the present value of the lost tax shield from the
proceeds of disposal, as shown in Exhibit 3.
The NPV plus the tax shield is:
= -52,910 -$151,269 + $86,273 – 5,191 = $33,363 -$70,187
The NPV is greater less than zero; therefore, the new machine to expand your business capacity is not
a good investment. However, the new machine is only marginally profitable if the cost of money is
7%. I have not considered the additional personal time and energy you will need to invest if you were
to expand your business capacity. I recommend considering a different alternative to invest your
inheritance.
PA1-11-CU28-ALL (Spring Session 3 Module 1 Self-Test Case NPV
calculation)
Page 1 of 4
Issued by CGA-Canada
March 23, 2012
COURSE UPDATE
Exhibit 1
Net Present Value (NPV)
The four inputs are used to determine the capital budgeting metrics below:
NPV = - CF0 +
E(CF1)
(1+k1)1
= - $500,000
+E(CF2) +
(1+k2)2
+ $70,000 (1 - .22)
(1.07)1
= -$52,910 -$151,269
E(CF3) +
(1+k3)3
+ $70,000 (1 - .22)
(1.07)2
…+
E(CF8)
(1+k8)8
+ $70,000 (1 - .22)…
(1.07)3
+ $120,000 (1 - .22)
(1.07)8
Exhibit 2
The present value of tax savings from depreciation (CCA) tax shelters over the (perpetual) life of an
asset can be computed by the following formula:
Present Value of the Tax Shield = CDT / (r+D) * (1 + 0.5r)/ (1+r)
where
C = Capital Cost or Undepreciated Capital Cost (UCC) of an asset
D = CCA rate of the class
T = marginal tax rate
r = after-tax discount rate cost of capital
This results in the following:
$500,000 x 30% x 22% x
0.07 + 0.30
= $86,273
1.035
1.07
Exhibit 3
The present value of the lost tax shield can be computed by the following formula:
Lost tax shield = (c x t) x (d/(d+r))
= (-$50,000 x 22%) x (30% /(30% + 7%)) = -$8,919
PV of lost tax shield = -$8,919/(1.07)8 = -$5,191
PA1-11-CU28-ALL (Spring Session 3 Module 1 Self-Test Case NPV
calculation)
Page 2 of 4
Issued by CGA-Canada
March 23, 2012
COURSE UPDATE
PK:FN:10 - Evaluates and advises on capital investments, mergers and acquisitions, or sale
of a business (analyzes potential acquisitions, projects post-acquisition synergies, prepares
and reviews valuation reports, formulates plans for joint ventures).
Baseline question: Did the candidate interpret the NPV and PV of the tax shield for the
proposed investment in machinery inside the corporation?
Performance
Level
Solution Key
0. NR/Inc
Did not attempt or there was insufficient response material to
evaluate or the answer provided was incorrect.
1. Substantially Stated that the incremental cash flows from use of the new
machinery would have to be ascertained to compute the payback
below
from the investment, but does not elaborate.
2. Below
3. Meets
4. Exceeds
Further stated that NPV net of the tax shield must be calculated to
ascertain whether the proposed investment in machinery must be
made and gave the formula to do the computations.
 Other
Stated the NPV of the tax shield must be calculated AND interpreted
the NPV net of tax shield as $33,363 -$70,187 for the proposed
investment AND stated that it may is not be considered a good
investment, given that it is more less than zero.
 Other
Stated the NPV of the tax shield must be calculated, interpreted the
NPV of the net tax shield, stated it may be is not a good investment,
AND recognized the new machine is not only marginally profitable if
the cost of money is 7%, and that personal time and energy have not
been considered in the said computation.

Other
PA1-11-CU28-ALL (Spring Session 3 Module 1 Self-Test Case NPV
calculation)
Page 3 of 4
Issued by CGA-Canada
March 23, 2012
COURSE UPDATE
PK:FN:06 - Develops financial plans and monitors forecasts in alignment with strategic and
operational plans of organizations and/or individuals (financial plans, projections, proposals, and trend
analyses; pro forma and projected financial statements; translates operational plans into cash
requirement plans).
Baseline question: Did the candidate interpret the annual cash flow information from the projected
income statement and identify metrics used for analyzing investments in new projects?
Performance Level
Solution Key
0. NR/Inc
Did not attempt or there was insufficient response material to
evaluate or the answer provided was incorrect.
Recognized that the annual cash flow of the investment must be
calculated to ascertain whether the proposed investment in
machinery should be made, but does not elaborate.
Further computed the incremental annual cash flows from the
investment would be $70,000, considering that depreciation is not
a cash outflow, but does not use it for analyzing the returns on the
said investment.
 Other
Interpreted metrics used for analyzing investments in new
projects as NPV, Internal rate of return (IRR), and payback.
 Other
Interpreted metrics used for analyzing investments AND stated
the inputs used in the investment analysis:
 A one-time net investment (-CF0)
 Future operating income or cash flows [E(CFi)]
 Estimated time period between the investment date and
the period in which the benefits arise (n)
 Firm’s cost of capital (ki)
 Other
1. Substantially below
2. Below
3. Meets
4. Exceeds
PA1-11-CU28-ALL (Spring Session 3 Module 1 Self-Test Case NPV
calculation)
Page 4 of 4
Issued by CGA-Canada
March 23, 2012