A proposed cost-saving device has an installed cost of $630,000. It is in Class
ID: 2642096 • Letter: A
Question
A proposed cost-saving device has an installed cost of $630,000. It is in Class 8 (CCA rate = 20%) for CCA purposes. It will actually function for five years, at which time it will have no value. There are no working capital consequences from the investment, and the tax rate is 35 percent.
What must the pre-tax cost savings be for us to favour the investment?
We require a 12 percent return. (Hint: this on wis a variation on the problem of setting a bid price)
Explanation / Answer
CCA gives tax shields to varied assets under different classes. For an investment to be feasible with specific returns required and no salvage value, the present value of the CCA tax shield for the first year needs to be found.
Present Value of CCA Tax Shield for Year 1 = CdT/d+k *(1+0.5k/1+k)
=$630,000*0.2*0.35/(0.2+0.12) * (1+0.5*.12)/(1+.12)
= 137,813 * 0.946429
= 130429.69
Thus, option C, i.e., $130,429.69 should be the pre-tax cost savings for us to favour the investment.