Question

Simmons Company is considering the purchase price of a new floor machine.

The purchase price of the equipment is $420,000 and it is expected to have a useful life of 7 years with no salvage value.

The company uses straight line depreciation and pays income taxes at a rate of 25%.

If the company requires that all new equipment investments pay for themselves within 3 years, how much annual cash operating savings must the floor machine generate, if it is to be bought.

Please show the steps in detail. I really want to learn the entire process here.

Thank you!

Answer 1

In this question, it is assumed that cash operating savings will be constant in each of the years. Also, time value of money concept is ignored since the same is not mentioned.

Investment of 420,000 will be made and it is required that the same be recovered in 3 years.

Hence, cash flows after tax saved per year should be 420,000/3 = 140,000

Basically, this is the flow to obtain cash flows after tax, taking starting point of cash operating savings

Cash operating savings

Less: Depreciation

Operating savings before tax

Less: Tax at 25%

Operating savings after tax

Add: Depreciation

Cash flows after tax

In this question, we have cash flows after tax (140,000) and we need cash operating savings.Hence, we will reverse the process and the "add" or "less" will also get reversed.

Cash flows after tax	140,000.00
Less: Depreciation (420000 divided by 7 years, under straight line method)	60,000.00
Operating savings after tax	80,000.00
Add: Tax (refer note below)	26,666.67
Operating savings before tax	106,666.67
Add: Depreciation	60,000.00
Cash operating savings	166,666.67

.Tax rate of 25% is applied on income. Hence, after tax income becomes 75%. In this case, operating savings after tax is 75% of the "before-tax" amount. Tax is calculated as 80000 / 75% * 25% = 26,666,67

Hence, the company should atleast have pre-tax cash operating savings of 166,666.67 per year