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In: Finance
Big-Pear Corp. is considering replacing its existing equipment that is used to produce smart cell phones....
Big-Pear Corp. is considering replacing its existing equipment that is used to produce smart cell phones. This existing equipment was purchase 2 years ago at a base price of $40,000. Installation costs at the time for the machine were $8,000. The existing equipment is considered a 5-year class for MACRS. The existing equipment can be sold today for $60,000 and for $30,000 in 4 years. The new equipment has a purchase price of $130,000 and is also considered a 5-year class for MACRS. Installation costs for the new equipment are $6,000. The estimated salvage value of the new equipment in year 4 is $90,000. This new equipment is more efficient than the existing one and thus savings before taxes using the new equipment are $16,000 a year. Due to these savings, inventories will see a one time reduction of $3,000 at the time of replacement. The company's marginal tax rate is 40% and the cost of capital is 12%. For this project, what is the incremental cash flow in year 3?
| MACRS Fixed Annual Expense Percentages by Recovery Class | |||||
| Year | 3-Year | 5-Year | 7-Year | 10-Year | 15-Year |
| 1 | 33.33% | 20.00% | 14.29% | 10.00% | 5.00% |
| 2 | 44.45% | 32.00% | 24.49% | 18.00% | 9.50% |
| 3 | 14.81% | 19.20% | 17.49% | 14.40% | 8.55% |
| 4 | 7.41% | 11.52% | 12.49% | 11.52% | 7.70% |
| 5 | 11.52% | 8.93% | 9.22% | 6.93% | |
| 6 | 5.76% | 8.93% | 7.37% | 6.23% | |
| 7 | 8.93% | 6.55% | 5.90% | ||
| 8 | 4.45% | 6.55% | 5.90% | ||
| 9 | 6.56% | 5.91% | |||
| 10 | 6.55% | 5.90% | |||
| 11 | 3.28% | 5.91% | |||
| 12 | 5.90% | ||||
| 13 | 5.91% | ||||
| 14 | 5.90% | ||||
| 15 | 5.91% | ||||
| 16 | 2.95% | ||||
Solutions
Expert Solution
| Tax rate | 40.00% | ||||||
| Old equipment | |||||||
| Cost (40000+8000) | $ 48,000 | ||||||
| Dep-year 1-2 (20%+32%) | $ 24,960 | ||||||
| WDV | $ 23,040 | ||||||
| Sale price | $ 60,000 | ||||||
| Gain/(Loss), (60000-23040) | $ 36,960 | ||||||
| Tax benefit | $ 14,784 | =36960*40% | |||||
| Sale price after tax | $ 45,216 | =60000-14784 | |||||
| Cost of new equipment (130000+6000) | $ 136,000 | ||||||
| Less sale proceed of old equipment | $ (45,216) | ||||||
| Net investment | $ 90,784 | ||||||
| Depreciation on new equipment | |||||||
| Year | Cost | Dep rate | Depreciation | Depreciation | |||
| 1 | $ 136,000 | 20.00% | =136000*20% | $ 27,200 | |||
| 2 | $ 136,000 | 32.00% | =136000*32% | $ 43,520 | |||
| 3 | $ 136,000 | 19.20% | =136000*19.2% | $ 26,112 | |||
| 4 | $ 136,000 | 11.52% | =136000*11.52% | $ 15,667 | |||
| Depreciation on old equipment | |||||||
| Year | Cost | Dep rate | Depreciation | Depreciation | |||
| 1 | $ 48,000 | 19.20% | =48000*19.2% | $ 9,216 | |||
| 2 | $ 48,000 | 11.52% | =48000*11.52% | $ 5,530 | |||
| 3 | $ 48,000 | 11.52% | =48000*11.52% | $ 5,530 | |||
| 4 | $ 48,000 | 5.76% | =48000*5.76% | $ 2,765 | |||
| Incremental depreciation | |||||||
| Year | New Depreciation | Old Depreciation | Additional depreciation | ||||
| 1 | $ 27,200 | $ 9,216 | $ 17,984 | ||||
| 2 | $ 43,520 | $ 5,530 | $ 37,990 | ||||
| 3 | $ 26,112 | $ 5,530 | $ 20,582 | ||||
| 4 | $ 15,667 | $ 2,765 | $ 12,902 | ||||
| After tax value of operating profits | |||||||
| Year | Cost saving | Dep rate | After tax saving | ||||
| 1 | $ 16,000 | =16000*(1-40%) | $ 9,600 | ||||
| 2 | $ 16,000 | =16000*(1-40%) | $ 9,600 | ||||
| 3 | $ 16,000 | =16000*(1-40%) | $ 9,600 | ||||
| 4 | $ 16,000 | =16000*(1-40%) | $ 9,600 | ||||
| Total | $ 38,400 | ||||||
| Tax shield | |||||||
| Year | Additional depreciation | Tax shield | Tax shield | ||||
| 1 | $ 17,984 | =17984*40% | $ 7,194 | ||||
| 2 | $ 37,990 | =37990.4*40% | $ 15,196 | ||||
| 3 | $ 20,582 | =20582.4*40% | $ 8,233 | ||||
| 4 | $ 12,902 | =12902.4*40% | $ 5,161 | ||||
| Total | $ 35,784 | ||||||
| Old equipment | New equipment | ||||||
| WDV |
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