Question

For example, Adelphi, Inc., is considering the purchase of a machine that would cost $370,000 now, and would last for 8 years. At the end of 8 years, the machine would have a salvage (disposal) value of $50,000.
The machine would reduce labor and other costs by $60,000 per year. All cost savings are assumed to occur at the end of each year.
Additional working capital of $5,000 would be needed immediately. All of this working capital would be recovered in cash at the end of the life of the machine.

The company requires a minimum pretax return of 10% on all investment projects.

The company has a 21% tax rate and uses the straight-line depreciation method.

1. What is the amount of annual depreciation on the new equipment?
2. How much tax does this new investment save per year from recording depreciation expense?
3. What is the amount of periodic annual after-tax net cash-flow from the use of this new machine? [Cash from depreciation tax shield and after-tax cash flow from cost savings]
4. Is the purchase of this machine acceptable based on its NPV?

Answer 1

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Part 1
Annual Depreciation for equipment		$   40,000
($370,000-$50,000)/8 Years
Part 2
Annual Depreciation for equipment		$   40,000
Tax Savinng on Depreciation 21%		$     8,400
Part 3
After tax saving in Cost $60,000*(1-0.21)		$   47,400
Add: Tax savining on Depreciation		$     8,400
Annual after tax cash flow		$   55,800
Part 4
		Cash Flow	PVF	PV
Present value of Annual after tax cash flow		$   55,800	5.3349	$ 297,687
Present value of salvage value		$   50,000	0.4665	$    23,325
Less: Initial Investment				$-370,000
NPV				$ -48,988
No, since NPV is negative