Question

The cost base of a machine is 100,000 dollars and the machine is expected to be fully functional for 5 years. The machine will provide a net income of 35,000 dollars in each of the 5 years. The machine will have no value by the end of the 5 year period. For the deprecation calculations, 150% declining balance method will be used. By using the fact that the income tax is 40% and minimum acceptable rate of return after 10% tax, calculate the current value of the machine.

Answer 1

Value of machine would be the NPV of the machine.

Depreciation as per the 150% declining balance method is computed as -

Depreciation = 1.5 x Straight line rate x Balance at the beginning of the year

Depreciation as per straight line = 100,000 / 5 = 20,000

Straight line rate = (Depreciation per year as per straight line / Cost of machine) x 100

or, Straight line rate = (20000 / 100,000) x 100 = 20%

Depreciation Tax Savings

Year	Balance at beginning	Depreciation	Balance at end	Depreciation tax savings
1	100,000	100,000 x 20% x 1.5 = 30,000	70,000	30,000 x 40% = 12,000
2	70,000	70,000 x 20% x 1.5 = 21,000	49,000	21,000 x 40% = 8,400
3	49,000	49,000 x 20% x 1.5 = 14,700	34,300	14,700 x 40% = 5,880
4	34,300	34,300 x 20% x 1.5 = 10,290	24,010	10,290 x 40% = 4,116
5	24,010	24,010 x 20% x 1.5 = 7,203	16,807	7,203 x 40% = 2,881.20

Present Value of Cash Inflows

Particulars Year 1 Year 2 Year 3 Year 4 Year 5 Net Income After tax 35,000 x (1 - 0.40) = 21,000 21,000 21,000 21,000 21,000 Add: Depreciation Tax savings 12,000 8,400 5,880 4,116 2,881.20 Total Cash Inflows 33,000 29,400 26,880 25,116 23,881.20 PVF @ 10% 0.90909090909 0.82644628099 0.7513148009 0.68301345536 0.62092132305 PV of Cash Inflows 30,000 24,297.52 20,195.34 17,154.57 14,828.35

Value of Machine = PV of Cash Inflows - Initial Outflow = $106,475.78 - $100,000 = $6,475.78