Question

A company is considering a $100,000 piece of equipment after securing a 3 year service contract. This equipment falls into the MACRS five year class and will be sold after three years for $42,000. The addition of this equipment will have no effect on revenues, but it is expected to save the company $45,000 per year in before-tax operating costs. The firm's marginal tax rate (federal plus state) is 40%, and its after-tax MARR is 12%.

Show if this investment is economically justifiable or not.

Answer 1

	Initial Investment	$100,000
Year	starting Book Value B	Deprecation Rate d	Depreciation D=d*Initial Inestment	End Of Year Book Value =B-D
1	100000	20%	20000	80000
2	80000	32%	32000	48000
3	48000	19.20%	19200	28800
4	28800	11.52%	11520	17280
5	17280	11.52%	11520	5760
6	5760	5.76%	5760	0

Year	Total Saving P	Depreciation D	Taxable Income TI=P-D	Tax T=40%*TI	Cashflow C
1	45000	20000	25000	10000	35000
2	45000	32000	13000	5200	39800
3	45000	19200	25800	10320	34680

Since machine is sold at $42000 after three years which is greater than book value($28800) after three years . So company has to pay tax on capital gain so Net salvage value S=42000-40%*(42000-28800)=$36720

Given MARR after tax=12%

To analyze the profitability of this machine we need to calculate net present value of this investment.

NPV=PV of all net cash flow + PV of Net salvage value- initial investment

NPV=35000/(1+12%)^1+39800/(1+12%)^2+34680/(1+12%)^3+36720/(1+12%)^3-100000=31250+31728.32+24684.54+26136.57-100000=$13799.43

Since we are getting positive NPV so this investment is economically justifiable.