Question

Dungan Corporation is evaluating a proposal to purchase a new drill press to replace a less efficient machine presently in use. The cost of the new equipment at time 0, including delivery and installation, is $250,000. If it is purchased, Dungan will incur costs of $7,000 to remove the present equipment and revamp its facilities. This $7,000 is tax deductible at time 0.

Depreciation for tax purposes will be allowed as follows: year 1, $60,000; year 2, $90,000; and in each of years 3 through 5, $50,000 per year. The existing equipment has a book and tax value of $120,000 and a remaining useful life of 10 years. However, the existing equipment can be sold for only $60,000 and is being depreciated for book and tax purposes using the straight-line method over its actual life.

Management has provided you with the following comparative manufacturing cost data.

	Present Equipment			New Equipment
Annual capacity (units)		420,000			420,000
Annual costs:
Labor	$	55,000		$	45,000
Depreciation		30,000			34,000
Other (all cash)		68,000			40,000
Total annual costs	$	108,000		$	79,000

The existing equipment is expected to have a salvage value equal to its removal costs at the end of 10 years. The new equipment is expected to have a salvage value of $80,000 at the end of 10 years, which will be taxable, and no removal costs. No changes in working capital are required with the purchase of the new equipment. The sales force does not expect any changes in the volume of sales over the next 10 years. The company’s cost of capital is 16 percent, and its tax rate is 25 percent. Use Exhibit A.8.

Required:

a. Calculate the removal costs of the existing equipment net of tax effects.

b. Compute the depreciation tax shield. (Round PV factors to 3 decimal places.)

c. Compute the forgone tax benefits of the old equipment.

d. Calculate the cash inflow, net of taxes, from the sale of the new equipment in year 10.

e. Calculate the tax benefit arising from the loss on the old equipment.

f. Compute the annual differential cash flows arising from the investment in years 1 through 10.

g. Compute the net present value of the project.

Answer 1