Question

Penny Company has an opportunity to sell some equipment for $40,000. Such a sale will result in a tax-deductible loss of $4,000. If the equipment is not sold, it is expected to produce net cash inflows after taxes of $8,000 for the next 10 years. After 10 years, the equipment can be sold for its book value of $4,000. Assume a 40% federal income tax rate.

Management currently has other opportunities that will yield 18%. Using the net present value method, show whether the company should sell the equipment. Prepare a schedule to support your conclusion.

Answer 1

Following information is given in the question for Penny Company:

1. Opportunity to sell some equipment for $40,000 that will result in a tax-deductible loss of $4,000
2. Net cash inflows after taxes of $8,000 for next 10 years if the equipment is not sold
3. Book value or sale value of equipment after 10 years is $4,000
4. Tax rate is 40%
5. Penny Company required rate of return is 18%

To conclude whether the company should sell the equipment or not can be evaluated by assessing two alternatives:

Alternative – A Sell the equipment

Alternative – B Not to sell the equipment

In both the alternatives there are different inflows and we have to compare the inflows from both alternatives to choose the best option.

Inflows from alternate – A Sell the equipment

Inflows at Year 0 = Sale value of the equipment – loss from sale of the equipment

Inflows at Year 0 = $40,000 - $4,000

Inflows at Year 0 = $36,000

Inflows from alternate – B Not to sell the equipment

Let us first compute the cash inflows from retaining the equipment for 10 years and thereafter we will calculate the net present value of the cash inflows and outflows.

For computing the cash inflows, we have to first calculate the annual depreciation, because depreciation charge is non cash in nature.

Depreciation = (Book value of the equipment in the beginning - Book value of the equipment at the end) / Life of the project

Where –

Book value of the equipment in the beginning = Sale value of equipment + loss from sale of equipment

Book value of the equipment in the beginning = $40,000 + $4,000

Book value of the equipment in the beginning = $44,000

Book value of the equipment at the end = $4,000 (given)

Life of the project = 10 years (given)

Putting the above figures in the formula, we get

Depreciation = (Book value of the equipment in the beginning - Book value of the equipment at the end)       / Life of the project

Depreciation = ($44,000 - $4,000) / 10

Depreciation = $40,000 / 10

Depreciation = $4,000 per annum

Statement showing annual cash flows from the equipment

Particulars	Year 1 to 10
Net cash inflows after taxes (A)	$      8,000.00
Tax @ 40% (B-A)	$      5,333.33
Net cash inflows before taxes (B = A/60%)	$    13,333.33
Depreciation (calculate above)	$    (4,000.00)
Profits before tax (C )	$      9,333.33
Tax @ 40% (C * 40%)	$    (3,733.33)
Profits after tax	$      5,600.00
Depreciation	$      4,000.00
Cash Flows	$      9,600.00

Statement showing Net Present Value from the equipment

Year	Particulars	Amount (A)	Discounted Factor @ 18% (B)	Present Value (A * B)
1 to 10	Cash Flows	$      9,600.00	4.4941	$        43,143.36
10	Sale value of the equipment	$      4,000.00	0.1911	$              764.40
Net Present Value				$         43,907.76

Hence, inflows from Alternative – A Sell the equipment is $36,000 and inflows from Alternative – B Not to sell the equipment is $43,907.76

On comparing both the alternatives we can conclude that Penny Company shouldn’t sell the equipment since it will create some extra cash inflows of $7,907.76 ($43,907.76 - $36,000) in terms of present value at the yield of 18%.