Question

Consider the case of Alexander Industries:

Alexander Industries is considering a project that requires an investment in new equipment of $3,360,000. Under the new tax law, the equipment is eligible for 100% bonus depreciation at t = 0 so the equipment will be fully depreciated at the time of purchase. Alexander estimates that its accounts receivable and inventories need to increase by $640,000 to support the new project, some of which is financed by a $256,000 increase in spontaneous liabilities (accounts payable and accruals). The company's tax rate is 25%.

The after-tax cost of Alexander’s new equipment is_____________

Alexander’s initial net investment outlay is_______________

Suppose Alexander’s new equipment is expected to sell for $200,000 at the end of its four-year useful life, and at the same time, the firm expects to recover all of its net operating working capital (NOWC) investment. Remember, that under the new tax law, this equipment was fully depreciated at t = 0. If the firm’s tax rate is 25%, what is the project’s total termination cash flow?

Answer 1

(a) Calcultion of after-tax cost of new machine  
Cost of equipment   -3360000
Tax benefit of 100%

bonus depreciation  
(3360000*100%*25%)   840000
__________________________________________________________  
After-tax cost of equipment -2520000
  
(b) Calcultion of Initial net outlay  
Aftertax cost   -2520000
Investment in working capital   -384000
  
__________________________________________________________  
Net initial outlay is   -2904000
  
(c) Calcultion of Terminal cash inflow  
Sale of equipment   200000
less: tax on capital gain   -50000
(200000*25%)  
Working capital recovered   384000
__________________________________________________________  
Terminal cash inflows is   534000
  
Note (1) old equipment is fully depreciated. So capital gain will be = Sale value - book value. That is 200000-0= 200000

tax will be payable on capital gain of $200000 at 25% = 50000

(2) Working capital = current assets - Current liabilities  
640000-256000=   384000
This is an investment. so it will be cash outflow of -$384000  

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