Question

Zaynab Inc. is considering a new 4-year expansion project that consists of setting up a new manufacturing plant. The initial investment in fixed assets is estimated to $3.1 million. The manufacturing plant falls into Class 10 for tax purposes (CCA rate of 30 percent per year). We assume that there is no salvage value for this project which is estimated to generate additional pre-tax sales of 2,500,000 per year. Annual pre-tax variable costs are expected to be $860,000 and annual pre-tax fixed costs would be $240,000 per year. Suppose that the required return on the project is 12 percent and that the corporate tax rate is 35 percent.

a- Compute the OCF at each year of the project.

b- Determine the DOL of the project in the 1st year. What will happen to the OCF if the quantity to be sold decreases by 10%?

c- What is the Present value of the CCA Tax Shield (PVCCATS)?

Answer 1

Answer - a

Statement showing Operating Cash Flow

Amount ($)

Particulars	Year 1	Year 2	Year 3	Year 4
Sales	2,500,000	2,500,000	2,500,000	2,500,000
Variable Cost	-860,000	-860,000	-860,000	-860,000
Fixed Cost	-240,000	-240,000	-240,000	-240,000
Capital Cost Allowance	-465,000	-790,500	-553,350	-387,345
Profit before tax	935,000	609,500	846,650	1,012,655
Tax @ 35%	-327,250	-213,325	-296,328	-354,429
Profit after tax	607,750	396,175	550,323	658,226
Capital Cost Allowance	465000	790500	553350	387345
Operating Cash Flow	1,072,750	1,186,675	1,103,673	1,045,571

Statement showing annual CCA

Year	Particulars	Working	Amount ($)
0	New Manufacturing Plant Cost		3,100,000
1	Capital Cost Allowance	(3,100,000 * 15%)	-465,000
1	Closing Balance of Plant		2,635,000
2	Capital Cost Allowance	(2,635,000 * 30%)	-790,500
2	Closing Balance of Plant		1,844,500
3	Capital Cost Allowance	(1,844,500 * 30%)	-553,350
3	Closing Balance of Plant		1,291,150
4	Capital Cost Allowance	(1,291,150 * 30%)	-387,345
4	Closing Balance of Plant		903,805

Note: The new manufacturing plant falls into Class 10 for tax purposes (CCA rate of 30 percent per year) and hence in the first year we can claim CCA of only half of this rate i.e. 15% and thereafter full rate of 30% can be claimed on the balance unamortised/ undepreciated amount of plant.

Answer - b

Degree of Operating Leverage (DOL) can be calculated using the below mentioned formula:

DOL = Contribution margin / Operating income

Where-

Contribution margin = Sales - Variable cost

Contribution margin = $2,500,000 - $860,000

Contribution margin = $1,640,000

Operating income = Sales - Variable cost - Fixed cost

Operating income = $2,500,000 - $860,000 - $240,000

Operating income = $1,400,000

On putting these figures in the above formula, we get-

DOL = Contribution margin / Operating income

DOL = $1,640,000 / $1,400,000

DOL = 1.1714

If the quantity to be sold decreases by 10% then the sales and variable cost will also be decreased by 10% and hence the revised sales figures will be $2,250,000 ($2,500,000 - 10% of $2,500,000) and the revised variable cost figures will be $774,000 ($860,000 - 10% of $864,000)

Statement showing Revised Operating Cash Flow

Amount ($)

Particulars	Year 1	Year 2	Year 3	Year 4
Sales	2,250,000	2,250,000	2,250,000	2,250,000
Variable Cost	-774,000	-774,000	-774,000	-774,000
Fixed Cost	-240,000	-240,000	-240,000	-240,000
Capital Cost Allowance	-465,000	-790,500	-553,350	-387,345
Profit before tax	771,000	445,500	682,650	848,655
Tax @ 35%	-269,850	-155,925	-238,928	-297,029
Profit after tax	501,150	289,575	443,723	551,626
Capital Cost Allowance	465,000	790,500	553,350	387,345
Operating Cash Flow	966,150	1,080,075	997,073	938,971

Note: Capital Cost Allowance (CCA) amount has been taken the same as calculated in Answer - a above

Answer - c

Present value of the CCA Tax Shield can be calculated usind the discount rate of 12% which is the required return on the project given in the question.

Statement showing computation of CCA Tax shield

Amount ($)

Year	CCA	Tax Shield (CCA * 35%)
1	465000	162750
2	790500	276675
3	553350	193673
4	387345	135571

Note: Capital Cost Allowance (CCA) amount has been taken the same as calculated in Answer - a above

Statement showing Present Value of CCA Tax shield

Year	Particulars	Amount ($) (A)	Discount Factor @ 12% (B)	Present Value ($)(A * B)
1	CCA Tax shield	162,750	0.89286	145,313
2	CCA Tax shield	276,675	0.79719	220,563
3	CCA Tax shield	193,673	0.71178	137,852
4	CCA Tax shield	135,571	0.63552	86,158
	Present Value of CCA Tax shield	589,886