A firm is considering the purchase of equipment which will cost $3 million. This equipment will last for 10 years, at the end of which it can be sold for $800,000. The CCA rate for this asset class is 30%, and the firm expects to have other assets in this asset class at the end of year 10. This equipment is expected to increase before-tax operating cash flows by $750,000 per year. However, in order to put the equipment to use, an additional $150,000 will need to be invested in net working capital initially (i.e., at t=0).
The required rate of return is 16% and the firm's marginal tax rate is 35%. (12 marks)
a. Should the firm purchase this equipment?
b. Suppose that to arrive at the before-tax operating cash flows in part (a), we have used the following estimates:
Fixed costs = $120,000
Variable costs = 60% of sales
What is the Net Present Value of the new equipment if, in the best-case scenario, we estimate that fixed costs could be lower by 20% and
sales revenues could be higher by 25%?
c. Given the information in (a), and assuming that fixed costs are $120,000 and variables costs are 60% of sales, what is the sales level at which Net Present Value equals zero? (In other words, what is the financial break-even sales level?)