Question

Your firm is contemplating the purchase of a new $435,000 computer-based order entry system. The system will be depreciated straight-line to zero over its 6-year life. It will be worth $54,000 at the end of that time. You will save $157,000 before taxes per year in order processing costs, and you will be able to reduce working capital by $43,000 at the beginning of the project. Working capital will revert back to normal at the end of the project. The tax rate is 23 percent.

What is the aftertax salvage value of the equipment? (Do not round intermediate calculations and round your answer to the nearest whole number, e.g., 32.)

What is the annual operating cash flow? (Do not round intermediate calculations and round your answer to the nearest whole number, e.g., 32.)

Answer 1

Solution:

Calculation of after tax salvage value of the equipment :

The formula for calculating the after tax salvage value is

= Salvage value * ( 1 – Tax rate )

As per the information given in the question we have

Salvage value = $ 54,000   ; Tax rate = 23 % ;

Applying the above information in the formula we have the after tax salvage value as

= $ 54,000 * ( 1 – 0.23 ) = $ 54,000 * 0.77

= $ 41,580

Thus the after tax salvage value of the equipment is = $ 41,580

Calculation of annual operating cash flow for year 1 to year 5 :

The Operating Cash Flow is calculated using the formula

= [ ( Savings in order processing costs – Annual Depreciation ) * ( 1 – Tax Rate ) ] + Annual Depreciation

As per the Information given in the question

Savings in order processing costs = $ 157,000     ; Tax Rate = 23 % = 0.23    ;

Straight line Depreciation = Cost of the equipment / Useful Life of the equipment

= $ 435,000 / 6 = $ 72,500

Thus annual depreciation = $ 72,500

Applying the above information in the formula for annual operating cash flow we have

= [ ( $ 157,000 - $ 72,500 ) * ( 1 – 0.23 ) ] + $ 72,500

= ( $ 84,500 * 0.77 ) + $ 72,500

= $ 65,065 + $ 72,500

= $ 137,565

Thus the annual Operating Cash Flow for Year 1 to Year 5 = $ 137,565

Calculation of annual operating cash flow for Year 6 :

The annual operating cash flow for Year 6 = [ ( Savings in order processing costs – Annual Depreciation ) * ( 1 – Tax Rate ) ] + Annual Depreciation + Net Working capital Investment Recouped + After tax salvage value

As per the information available we have

Savings in order processing costs = $ 157,000 ; Annual Depreciation = 72,500   ; Tax Rate = 23 % = 0.23   ; Net Working capital Investment Recouped = $ 43,000 ;   After tax salvage value = $ 41,580

Thus the annual operating cash flow for Year 6 is

= [ ( $ 157,000 - 72,500 ) * ( 1 – 0.23 ) ] + $ 72,500 + $ 43,000 + $ 41,850

= $ 65,065 + $ 72,500 + $ 43,000 + $ 41,850

= $ 222,415

The annual operating cash flow for Year 6 = $ 222,415