Question

Terminal cash- Various lives and sale prices.    Looner Industries is currently analyzing the purchase of a new machine that cost. $164,000 and requires $19,800

in installation costs. Purchase of this machine is expected to result in an increase in net working capital of $30,100 to support the expanded level of operations. The firm plans to depreciate the machine under MACRS using a​ 5-year recovery period​ .for the applicable depreciation​ percentages) and expects to sell the machine to net $10,300 before taxes at the end of its usable life. The firm is subject to a 40 % tax rate.

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.

c.  Assuming a​ 5-year usable​ life, calculate the terminal cash flow if the machine were sold to net​ (1) $9,190 or​ (2) $169,600 ​(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.

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%

Answer 1

Total cost = purchase price + installation cost = 164,000 + 19,800 = 183,000

Terminal cash flow = recovery of working capital + after-tax salvage value

After-tax salvage value = selling price - tax rate*(selling price - book value at the end of usable life)

3-year MACRS depreciation schedule:

After-tax salvage value = 10,300 - 40%*(10,300-13,619.58) = 11,627.80

Terminal cash flow for 3 year life = 30,100 + 11,627.80 = 41,727.83

5-year MACRS depreciation schedule:

After-tax salvage value = 10,300 - 40%*(10,300-10,586.88) = 10,414.80

Terminal cash flow for 5 year life = 30,100 + 10,414.80 = 40,514.75

7-year MACRS schedule:

After-tax salvage value = 10,300 - 40%*(10,300-8,197.48) = 9,458.99

Terminal cash flow for 7 year life = 30,100 + 9,458.99 = 39,558.99

Note: Depreciation rates have not been rounded off as given in the table in the question. Exact rates have been taken. If rounded off rates are taken, then calculated numbers will differ slightly.

b). As can be seen, with the increase in usable life, the terminal cash flow decreases. This is so because the book value of the asset decreases with usable life so that the salvage value over time decreases, leading to decreasing terminal cash flows.

c). After-tax salvage value when selling price is 9,190:

9,190 - 40%*(9,190-10,586.88) = 9,748.75

Terminal cash flow = 30,100 + 9,748.75 = 39,848.75

After-tax salvage value when selling price is 169,600:

169,600-40%*(169,600-10,586.88) = 105,994.75

Terminal cash flow = 30,100 + 105,994.75 = 136,094.75

d). As is to be expected, as sales price increases, the after-tax salvage value increases (given that life of asset remains same), as well, leading to an increase in the terminal cash flow.