Question

Gluon Inc. is considering the purchase of a new high pressure glueball. It can purchase the glueball for $60,000 and sell its old low-pressure glueball, which is fully depreciated, for $10,000. The new equipment has a 10-year useful life and will save $14,000 a year in expenses. The opportunity cost of capital is 11%, and the firm’s tax rate is 40%. What is the equivalent annual savings from the purchase if Gluon uses straight-line depreciation? Assume the new machine will have no salvage value. (Do not round intermediate calculations. Round your answer to 2 decimal places.)

Answer 1

Years (n) =	10
Disount rate (r)= 11% or	0.11
Calculation of initial investment
cost of machine	-60000
Sale proceeds of old machine	10000
Tax on old machine	-4000
(10000*40%)
Intial investment =	-54000
Calculation of Annual free Cash flow
Savings in expenses	14000
less: Depreciation (60000/10)	-6000
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Profit before tax	8000
less: tax @ 40%	-3200
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Profit after tax	4800
Addback : Depreciation	6000
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Annual free cash flow	10800
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Equivalent Annual Annuity formula = Initial Investment * r/ {1- (1/1+r)n) } + Annual free cash flow
(-54000*0.11 /(1-(1/((1+0.11)^10))))+10800
1630.722937
So, Equivalent annual savings is $1630.72
Note (1) old equipment is fully depreciated. So tax will be payable on capital gain of $36000
(2) Depreciation is deducted for tax purposes only. It will be added back as it is non-cash expenditure