Question

Looner Industries is currently analyzing the purchase of a new machine that costs $165,000

and requires $19,800in installation costs. Purchase of this machine is expected to result in an increase in net working capital of $30,400to support the expanded level of operations. The firm plans to depreciate the machine under MACRS using a​ 5-year recovery period​ (see the table

LOADING...for the applicable depreciation​ percentages) and expects to sell the machine to net

$10,400 before taxes at the end of its usable life. The firm is subject to a 40 % tax rate.

Rounded Depreciation Percentages by Recovery Year Using MACRS for First Four Property Classes
	Percentage by recovery year*
Recovery year	3 years	5 years	7 years	10 years
1	33%	20%	14%	10%
2	45%	32%	25%	18%
3	15%	19%	18%	14%
4	7%	12%	12%	12%
5		12%	9%	9%
6		5%	9%	8%
7			9%	7%
8			4%	6%
9				6%
10				6%
11				4%
Totals	100%	100%	100%	100%

a. Calculate the terminal cash flow for a usable life of ​ (1) 3​ years, (2) 5​ years, and​ (3) 7 years.

b. Discuss the effect of usable life on terminal cash flows using your findings in part a.

assuming a​ 5-year usable​ life, calculate the terminal cash flow if the machine were sold to net​ (1) $9,240

or​ (2) $170,500(before taxes) at the end of 5 years.

d. Discuss the effect of sale price on terminal cash flow using your findings in part c.

Answer 1

Firstly we will compute the total value of cost of machine as the cost of machine includes the cost of installation.

cost of New machine	$165000
Installation cost	$19,800
Total cost of machine	$184800

Step 1 : part a :Calculate the terminal cash flow for a usable life of ​ (1) 3​ years, (2) 5​ years, and​ (3) 7 years

Expected selling price of machine :$10,400(given)

Increase in working capital change : $30,400(given)

Scrap value -nill(assumed)(so ignoring in computation)

Terminal cash flow : salvage or scrap value +tax saving on loss of asset or ( -) Tax burden on gain on sale of asset +release of working capital.

Particulars	3 years	5 years	7 years
a)selling price	$10400	$10400	$10400
b)Book value of machine	184800	184800	184800
c)Cummulative depreciation charged on machine	(144144)	(171864)	(184800)
d)remaining value(b-c)	40656	12936	-
e)Profit /loss on sale(a-d)	(30256)	(2536)	10400
f)tax saving on sale of asset	12,102.4	1014.4
g) tax gain in sale of asset			4160
h)net working capital	$30,400	$30,400	$30,400
Terminal value	$42502.4	$31414.4	$26240

step 2 : part b:Discuss the effect of usable life on terminal cash flows using your findings in part a.

From part a we can conclue the terminal value is more in year 3 as compared to year 5 when the machine is sold in the less than the remaining book value.

Step 3 :part c:assuming a​ 5-year usable​ life, calculate the terminal cash flow if the machine were sold to net​ (1) $9,240or​ (2) $170,500(before taxes) at the end of 5 years

Particulars	5 years	7 years
a)selling price	$9400	$170500
b)Book value of machine	184800	184800
c)Cummulative depreciation charged on machine	(171864)	(184800)
d)remaining value(b-c)	12936	-
e)Profit /loss on sale(a-d)	(3536)	170500
f)tax saving on sale of asset	1414.4
g) tax gain in sale of asset		68200
h)net working capital	$30,400	$30,400
Terminal value	$31814.4	$(68200)

step 4:part d:Discuss the effect of sale price on terminal cash flow using your findings in part c.

As a result of high selling price in year 5 i.e 170500 the 5th year 's terminal value is negative which means as a result of increase in tax burdern there will be an outflow $68200. whereas the selling price of year 3 is lessthan the remaining book value as a result there is tax saving and the terminal cash flow is positive.