Question

Assume that laban Company is considering the purchase of a newer, more efficient yogurt-making
machine. If purchased, it would require the new machine on January 2, year 1. laban expects to sell
600,000 gallons of yogurt in each of the next five years at a $2 per gallon selling price.
laban has two options:

(1) continue to operate the old machine purchased four years ago or
(2) sell it and purchase the new machine.

The following information has been prepared to help decide which option is more desirable.

	old machine	new machine
Original cost of machine at acquisition	$1,600,000	$2,000,000
Useful life from date of acquisition	7 years	5 years
Expected annual cash operating expenses:
variable cost per gallon	$1.20	$1.00
total fixed cash costs	$400,000	$160,000

depreciation is as follows:

age of equipment (years)	tax depreciation rate
1	15%
2	25%
3	20%
4	20%
5	20%

Estimated cash value of machines follows:	old machine	new machine
January 2, year 1	$ 400,000	$ 200,000,000
31 December, year 3	$ 200,000	$ 100,000,000

laban is subject to a 40% income tax rate on all income. Assume that tax depreciation is calculated
without regard to salvage value. Use an after-tax discount rate of 10%.

Answer 1

			DEPRECIATION OF OLD MACHINE
			Original Cost of OLD machine	$1,600,000
			Year(frompurchase date)	1	2	3	4	5	6	7
		A	5 year MACRS depreciation Rate	15.00%	25.00%	20.00%	20.00%	20.00%	0.00%	0.00%
		B1=A*1600000	Depreciation	$240,000	$400,000	$320,000	$320,000	$320,000	$0	$0
			Accumulated Depreciation	$240,000	$640,000	$960,000	$1,280,000	$1,600,000	$1,600,000	$1,600,000
			Year(from purchase date)	5	6	7
		N	Year FromToday	1	2	3	4	5
		B1	Depreciation 0f old Existing Machine	$320,000	$0	$0	$0	$0
			Book Value of existing machine now	$320,000	(1600000-1280000)
			Before tax salvage value	$400,000
			Gain on sale	$80,000
			Tax on Gain =80000*40%	$32,000
			After tax Cash Flow on Salvage in year0	$368,000	(400000-32000)
			DEPRECIATION OF NEW MACHINE
			Cost New Machine	$2,000,000
		N	Year(from today)	1	2	3	4	5
		A	5 year MACRS depreciation Rate	15.00%	25.00%	20.00%	20.00%	20.00%
		B2=A*2000000	Depreciation	$300,000	$500,000	$400,000	$400,000	$400,000
			Before tax salvage value	$1,000,000
			After tax salvage value=1000000*(1-0.4)	$600,000
			After tax salvage value of old machine at year5	$120,000	(200000*(1-0.4)
			Incremental Salvage Value =600000-120000	$480,000
			Present value of Cash Flow=(Cash Flow)/((1+i)^N)
			i=discount Rate =10.0%=0.10
			N=Year of Cash Flow
		N	Year From Today	1	2	3	4	5
		C=B2-B1	Incremental Depreciation	($20,000)	$500,000	$400,000	$400,000	$400,000
		D=C*40%	Incremental Depreciation tax shield	($8,000)	$200,000	$160,000	$160,000	$160,000