Question

Big-Pear Corp. is considering replacing its existing equipment that is used to produce smart cell phones. This existing equipment was purchase 3 years ago at a base price of $60,000. Installation costs at the time for the machine were $7,000. The existing equipment is considered a 5-year class for MACRS. The existing equipment can be sold today for $40,000 and for $20,000 in 3 years. The new equipment has a purchase price of $140,000 and is also considered a 5-year class for MACRS. Installation costs for the new equipment are $5,000. The estimated salvage value of the new equipment is $80,000. This new equipment is more efficient than the existing one and thus savings before taxes using the new equipment are $20,000 a year. Due to these savings, inventories will see a one time reduction of $1,000 at the time of replacement. The company's marginal tax rate is 30% and the cost of capital is 12%. For this project, what is the incremental cash flow in year 2?

MACRS Fixed Annual Expense Percentages by Recovery Class
Year	3-Year	5-Year	7-Year	10-Year	15-Year
1	33.33%	20.00%	14.29%	10.00%	5.00%
2	44.45%	32.00%	24.49%	18.00%	9.50%
3	14.81%	19.20%	17.49%	14.40%	8.55%
4	7.41%	11.52%	12.49%	11.52%	7.70%
5		11.52%	8.93%	9.22%	6.93%
6		5.76%	8.93%	7.37%	6.23%
7			8.93%	6.55%	5.90%
8			4.45%	6.55%	5.90%
9				6.56%	5.91%
10				6.55%	5.90%
11				3.28%	5.91%
12					5.90%
13					5.91%
14					5.90%
15					5.91%
16					2.95%

Answer 1

Incremental cash flow in Year 2 will only consist of After tax operating cash flow from project in year 2

Total cost of existing equipment purchased three years ago = Base cost + installation cost = 60000 + 7000 = 67000

At end of year 2, it will be 5 years since the purchase of existing equipment,so

Depreciation for existing equipment in year 2 = Total cost of existing equipment x Rate of depreciation for year 5 under MACRS 5 year class = 67000 x 11.52% = 7718.40

Total cost of new equipment = Purchase price + installation cost = 140000 + 5000 = 145000

Depreciation for new equipment in year 2 = Total cost of new equipment x Rate of depreciation for year 2 under MACRS 5 year class = 145000 x 32% = 46400

Incremental depreciation = Depreciation for new equipment in year 2 - Depreciation for existing equipment in year 2 = 46400 - 7718.40 = $38681.60

Incremental revenues - Incremental cost = Savings from new equipment = $20000

After tax operating cash flow in year 2 = (Incremental revenues - Incremental cost - Incremental depreciation)(1-tax rate) + Incremental depreciation = (20000 - 38681.60)(1-30%) + 38681.60 = -18681.60 x 70% + 38681.60 = -13077.12 + 38681.60 = $25604.48

Incremental cash flow in year 2 = After tax operating cash flow in year 2 = $25604.48