Question

A firm has purchased for $14,000 a machine with a five year useful life. The machine will be
depreciated using ADS on a three-year depreciation schedule. The uniform annual benefits are
$3600. The firm’s effective tax rate is 47% and the MARR before tax is 10%. The firm estimates
that there is a 40% likelihood that the machine will have a salvage value of $5,000 and
due to the probability of obsolescence, a 60% likelihood that the machine will have no salvage
value. Determine if this is a satisfactory investment.

Answer 1

	DEPRECIATION TAX SHIELD
	3 Year ADS depreiation:
	Cost of Asset	$14,000		Tax Rate=47%
		A	B=A*$14000	C=B*47%
	Year	Recovery Rate	Annual Depreciation	Depreciation Tax shield
	1	16.67%	$2,334	$1,097
	2	33.33%	$4,666	$2,193
	3	33.33%	$4,666	$2,193
	4	16.67%	$2,334	$1,097
	Salvage Value:	Probability	Salvage Value*Probability
	$5,000	40.00%	$2,000
	$0	60.00%	$0
		SUM	$2,000
	Expected Salvage Value	$2,000
	After tax Salvge value=2000*(1-0.47)=	$1,060
	After Tax MARR =10*(1-0.47)=	5.30%
	Present Value of Cash Flow
	(Cash Flow)/((1+i)^N)
	i= Discount Rate= MARR=5.3%=0.053
	After Tax annual benefit =3600*(1-0.47)	$1,908
N	Year	0	1	2	3	4	5
A	Initial Cash Flow	($14,000)
B	AnnualBenefit(after tax)		$1,908	$1,908	$1,908	$1,908	$1,908
C	Depreciation tax shield		$1,097	$2,193	$2,193	$1,097
D	After tax salvage value						$1,060
E=A+B+C+D	Net cash flow	($14,000)	$3,005	$4,101	$4,101	$3,005	$2,968	SUM
PV=E/(1.053^N)	PresentValue of Cash Flow	($14,000)	$2,854	$3,699	$3,513	$2,444	$2,293	$801
NPV=Sumof PV	Net Present Value	$801
	Yes, It is a satisfactory investment
	NPV is positive