Question

You are currently working as an independent consultant for Cong Nghiep Constructions and LPG (Liquefied Petroleum Gas) company. You have been asked by the president to evaluate the proposed acquisition of a new earth mover. The mover’s basic price is $50,000, and it would cost another $10,000 to modify it for special use. Assume that the mover falls into the MACRS 3- year class, it would be sold after 3 years for $20,000, and it would require an increase in net working capital (spare parts inventory) of $2,000. The earth mover would have no effect on revenues, but it is expected to save the firm $30,000 per year in before-tax operating costs, mainly labor. The firm’s tax rate is 40%.

a/ What is the depreciable basis for the earth mover?

b/ Is there a tax effect when selling the earth mover? What is the net cash flow from selling the earth mover?

c/ If the project’s cost of capital is 10%, should the earth mover be purchased? Show your calculations

	Property Class
Year	3-year	5-year	7-year
1	33.33%	20.00%	14.29%
2	44.45%	32.00%	24.49%
3	14.81%	19.20%	17.49%
4	7.41%	11.52%	12.49%
5		11.52%	8.93%
6		5.76%	8.92%
7			8.93%
8			4.46%

Answer 1

Answer :

(a.) Depreciable Base = Cost of Purchase + Cost to Modify

= 50000 + 10000

= 60000

(b.) There is tax Effect on selling Mover

Book Value = 60000 * 7.41% = 4446

Gain on Sale = Salvage Value - Book Value

= 20000 - 4446

= 15554

Tax on Gain on Sale = 15554 * 0.40 = 6221.6

Net cash flow from selling the earth mover = 20000 - 6221.6 = 13778.4

(c.) To decide whether earth mover should be pruchased or not we need to calculate NPV

	Year 0	Year 1	Year 2	Year 3
Initial Investment ( 50000 + 10000)	60000
Saving in Operating Cost		30000	30000	30000
Less : Depreciation (Working Note)		19998	26670	8886
Earning before taxes		10002	3330	21114
Taxes @ 40%		-4000.8	-1332	-8445.6
Earnings After Taxes		6001.2	1998	12668.4
Add : Depreciation		19998	26670	8886
Plus : Salvage Value				20000
Less : tax on salvage @ 40%				6221.6
NWC	2000
Plus : Recapture of NWC				2000
Operating Cash Flows	62000	25999.2	28668	37332.8
PV Factor @ 10%	1	0.909091	0.826446	0.751315
PV of Net Cash flows (Inflow)		23635.64	23692.56	28048.69
PV of Net Cash flows (Outflow)	62000
The net present value (NPV) of this project is		= $13376.88355 or $ 13376.88
NPV = PV of cash inflow - PV of cash outflow
= 75376.88355- 62000
= $13376.88355 or $ 13376.88
Working Note :
Year 1 : 60000 * 33.33% = 19998
Year 2 : 60000 * 44.45% = 26670
Year 3 : 60000 * 14.81% = 8886
Book Value = 60000 * 7.41% = 4446
Gain on Sale = Salvage Value - Book Value
= 20000 - 4446
= 15554
Tax on Gain on Sale = 15554 * 0.40 = 6221.6

Since it has positive NPV therefore Earth Mover should be purchased.