Question

McPherson Company must purchase a new milling machine. The purchase price is $50,000, including installation. The machine has a tax life of 5 years, and it can be depreciated according to the following rates. The firm expects to operate the machine for 4 years and then to sell it for $12,500. If the marginal tax rate is 40%, what will the after-tax salvage value be when the machine is sold at the end of Year 4?

Answer 1

Concept of After-tax salvage value is very straigh forward. If you salvage value before paying any tax is more than the book value of the asset, you have to pay taxes on the excess amount.

Follow the steps given below to calculate after tax salvage value -

1. Based on the depreciation rates provided, calculate $ depreciation for each year.
2. Calculate cumulative depreciation by summing up all the yearly deprectation amounts.
3. Deduct the cumulative deprectation from the original book value, to compuete book value at the time of salvage
4. Compute net gain(loss) by deducting terminal book value from salvage value
5. If the net gain is there (number is positive), multiply the gain with marginal tax rate to compute $ amount of tax
6. Finally, deduct $ amount of tax from pre-tax salvage value to get the post tax salvage value.

Formula used -

1. Dollar-depreciation = Original Book Value*Depreciation Rate
2. Cumulative Depreciation = Sum of all previous year depreciations
3. Terminal Book Value = Original Book Value - Cumulative Depreciation
4. Gain(Loss) on Salvage = Salvage Value - Terminal Book Value
5. Tax = Gains(If any)*Marginal Tax Rate
6. After Tax Salvage Value = Salvage Value - Tax

Formulas have been shown in the excel below -

Values in excel will look like below -

After tax salvage value = $10,900