Commerce 2FA3
Tutorial 8
March 2001
Question 1:
TTR is considering building a new warehouse (class 1, 4%) on a
piece of land that was purchased 5 years ago for $150,000. The
market value of the land has increased by 8% per year. The capital
gains inclusion rate is 50%. The warehouse would cost $600,000 to
build and would paid for with $350,000 cash and a 10-year $250,000
mortgage bond issue with a coupon rate of 6%. If TTR has a cost of
capital of 10% and a marginal tax rate of 42%, what is the effective
after-tax cost of this warehouse?
Direct Cost of Warehouse
Cost = $600,000
Opportunity Cost of Land
Market value = $150,000 x (1 + 0.08) 5 = $220,399
Capital Gain = 220,339 - 150,000 = 70,399
CG tax = 70399 x 50% x 42% = 14,784
Net opportunity cost = $205,615
PV of CCA Tax Shield
PVtax shield
r
CdTc 1  2 



r  d  1 r 



600,000  4%  42% 1.05

10%  4%
1.10
 $68,727
Net Cost
CF 0 = 600,000 + 205,615 - 68,727 = $736,888
Commerce 2FA3
Tutorial 8
March 2001
Question 2:
PFH Inc. is considering purchasing a new computer (CCA class 10,
30%) for $10,000. PFH's marginal tax rate is 40% and their cost of
capital is 14%. What is the present value of the tax shield under the
following conditions?
1. The class is currently empty.
PVtax shield
r
CdTc 1  2 



r  d  1 r 



10,000  30%  40% 1.07

14%  30%
1.14
 $2,560
2. The class has net dispositions of $15,000 this year.
With net dispositions, the half-year rule does not apply, so
the 1.07/1.14 factor is not needed.
PV = $2,560 x (1.14/1.07) = $2,727
3. The class has a current balance of -$15,000.
The company is currently facing recaptured depreciation of
$15,000. If they buy this machine and add it to that class,
the recapture is only $5,000. A tax saving of $10,000 x
40% or $4,000.
Commerce 2FA3
Tutorial 8
March 2001
Question 3:
GWH Inc. bought some production machinery (class 8, 20%) 3 years
ago. The machine cost $75,000 and was expected to last 10 years
with a salvage value of $25,000. The machine could be sold today
for $60,000. Due to increased demand, it has been proposed that the
machine should be replaced by a high volume machine that costs
$300,000 with an expected life of 7 years and a salvage value of
$25,000. The new machine would allow GWH to increase sales by
$200,000 per year with increased costs of $95,000. Prices and costs
are expected to increase at a rate of 2.5% per year. The machine is
quite efficient and is not expected to change the level of inventory.
A/R has been quite consistent at 5% of sales. GWH has an average
tax rate of 27.5% and a marginal tax rate of 36%. Using NPV with a
cost of capital of 12%, should GWH accept this project?
Net Purchase Price = 300,000 - 60,000 = $240,000
Tax Shield = CdT/(r+d) x (1+r/2)/(1+r) = $51,107
 Salvage Value = 0.
No net change.
 Annual cash flow = (200,000 - 95,000) x (1.025) t-1
 Working Capital =  Sales x 5%
Taxes = 36% x (Sales - costs)
Note: Increase in accounts payable is not tax deductible.
Increase in working capital is likely permanent.
Continued…
Commerce 2FA3
Tutorial 8
March 2001
Question 3: continued
Year
Sales
Costs
 WC
Taxes
Net CF
PV
1
200,000
95,000
10,000
37,800
57,200
51,071
2
205,000
97,375
250
38,745
68,630
54,711
3
210,125
99,809
256
39,714
70,346
50,071
4
215,378
102,305
263
40,706
72,104
45,824
5
220,763
104,862
269
41,724
73,907
41,937
6
226,282
107,484
276
42,767
75,755
38,380
7
231,939
110,171
283
43,836
77,649
35,124
317,118
Present Value of Operating Revenue = $317,118
NPV = - Net Price + PV Tax Shield + PV Operating Revenue
NPV = - $240,000 + $51,107 + $317,118 = $128,225
Note: If working capital can be recovered, the NPV increases by
$5,246 the present value of the sum of the  WC.