Question

Barney Marina is considering the purchase of a new winch. Fully installed, the
winch will cost $42,000. It will be depreciated at the rate of 20% (reducing
balance) and have a life of three years, at which time the salvage value will be
$1,000. The following before tax cash flows are forecast:-
Year 1 $31,000
Year 2 $25,000
Year 3 $20,000
Barney Marina cannot pay franked dividends, it has a required rate of return of
12% and pays tax at the rate of 30%.
Should the company purchase the machine?

Answer 1

Let us calculate the book value and depreciation per year.

Year	Initial Book Value	Depreciation @20%	Closing Book Value
1	42000	8400	33600
2	33600	6720	26880
3	26880	5376	21504

Let us calculate the PV of after tax cash flows.

We observe that salvage value of $1000 is lower than closing Book value of machine at the end of year 3. It means that firm will incur an ordinary loss.

Taxable income=Salvage-Book Value =1000-21504=-$20504

In this case, we assume that benefit of tax due to this ordinary loss can be adjusted with the other projects of firm. Its why ATCF is coming at the end of year 3 shown for salvage.

Year, n	BTCF	Depreciation	Taxable Income, TI= BTCF-D	Tax @30%	ATCF= BTCF-TI	PV= BTCF/(1+12%)^n
0	-42000				-42000.00	-42000.00
1	31000	8400	22600	6780.00	24220.00	21625.00
2	25000	6720	18280	5484.00	19516.00	15558.04
3	20000	5376	14624	4387.20	15612.80	11112.88
3	1000		-20504	-6151.20	7151.20	5090.08
NPV						11386.00

We find that NPV is positive at 12% discount rate. It means that proposal is acceptable. Company can go for the machine.