Question

Russell Industries is considering replacing a fully depreciated machine that has a remaining useful life of 10 years with a newer, more sophisticated machine. The new machine will cost $350,000 and will require $30,000 in installation costs. It will be depreciated under MACRS using a 5-year recovery period. A $25,000 increase in net working capital will be required to support the new machine. The firm’s managers plan to evaluate the potential replacement over a 4-year period. They estimate that the old machine could be sold at the end of 4 years to net $15,000 before taxes; the new machine at the end of 4 years will be worth $75,000 before taxes. Calculate the terminal cash flow at the end of year 4 that is relevant to the proposed purchase of the new machine. The firm is subject to a 40% tax rate.

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Answer 1

Computation of Terminal Cash flows

S.No	Particulars	Amount
A	Proceeds from sale of New Machine	$75,000
B	Tax on sale of new machine( Wn 1)	$3,734.40
C	After Tax proceed from the sale of New Asset( A-B)	$71,265.60
D	Proceeds from sale of Old Machine	$15,000
E	Tax on sale of Old Machine( D*40%)	$6,000.00
F	After Tax proceed from the sale of Old Asset( D-E)	$9,000.00
G	Change in Net Working Capital	$25,000
H	Terminal Cash flow( C-F+G)	$87,265.60

Hence the Terminal Cash flow in the Fourth yeaar is $ 87265.60

* Terminal Cash flow = After Tax proceeds from sale of New Assets- After tax proceeds of old Assets+Change in Net Working Capital

*Since the old machine is fully depreciated so tax will be applicable on entire sale proceeds

Computation of Book Value of Machine at the End of the Fourth Year

Year	Depreciation Calculation	Depreciation	Accumulated Depreciation'
1	$ 380000*20%	$76,000.00	$76,000
2	$ 380000*32%	$121,600.00	$ 760006$ 121600=$ 197600
3	$ 380000*19.2%	$72,960.00	$ 197600+$ 72960=$ 270560
4	$ 380000*11.52%	$43,776.00	$ 270560+$ 43776=$ 314336
	Total	$314,336.00

Book Value of Machinary at the end of 4 th year =Cost of Machinary - Accumulated epreciation

= $ 380000-$ 314336

= $ 65664

* Installation Cost is a part of the Cost of the machinary. So it has to be Capitalized.

Computation of Tax on sale of New machine( Wn 1)

S.No	Particulars	Amount
A	Sale value of Asset	$75,000
B	Book Value of Asset	$65,664.00
C	Gain on sale ( A-B)	$9,336.00
D	Tax @ 40% on Gain on sale i.e on C	$3,734.40

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