Question

Shade Your Eyes, Inc. makes sunglasses that cost $115 per pair. They want to buy equipment necessary to reduce their costs by $1 per pair.  It will cost $350,000 and will be depreciated on a straight-line basis over the 6-year life of the machine.   There is no increase in Net Working Capital for this project.  The margin before is $310,900, and with the new machine it will increase to $475,100.

The required return is 15%, and the tax rate is 40%.

You want to determine if you should buy this new equipment.

11) What is the change in Operating Cash Flow (OCF) (6 points)?

Answer 1

Given as per Question :

Cost of Additonal Equipment = 350,000$

Life of Equipment = 6 Years

Old Margin = 310,900$

New Margin = 475,100$

Tax Rate = 40%

Answer:

A. Additonal Relevent Costs

1. Depreciation of the equipment = Purchase Cost/ Life of the equipment

= 350,000 $ / 6

    = 58,333.33 $

2. Tax savings on depreciation = Depreciation * Tax Rate

= 58,333.33 $ * 40%

= 23,333.33 $

Net Additional Relevant Cost = Depreciation - Tax savings on depreciation

= 58,333.33 $ - 23,333.33 $

Net Additional Relevant Cost (A) = 35,000 $

B. Additonal Relevent Savings

1. Additional Margin = New Margin - Old Margin

= 475,000 $ - 310,900 $

= 164,200 $

2. Tax on savings = Additional Margin * Tax rate

= 164,200 * 40%

= 65,680 $

Net Additional Savings = Additonal Margin - Tax on savings

= 164,200 $ - 65,680 $

Net Additional Savings (B) = 98,520 $

Net Savings on the purchase of equipment = Net Additional Savings (B) - Net Additional Relevant Cost (A)

= 98,520 $ - 35,000 $

=63,520 $

Decision : Since there is an additonal net saving of $ 63,520, Shade Your Eyes, Inc. should purchase the equipment.

The change in Operating Cash Flow = Inflow of $ 63,520