Question

Rogers, Inc., is considering replacing its existing assembly line with a new upgraded model. The CEO of thecompany, John Rogers, makes $150,000 a year and is in the personal 35% marginal income tax bracket. Aconsulting company in Mr. Rogers’ neighborhood provided the following information about the economiceffects of the replacement:The cost of the upgraded assembly line is estimated to be $500,000 plus installation costs of $50,000.The technology on the upgraded model is more sophisticated than what is on the current model and theemployees would have to be trained how to operate it. The training would occur immediately at a cost$35,000. Training is a tax deductible expense and would be immediately deducted.The new assembly line would require fewer workers and less electricity. The projected before-tax costssavings are $120,000 the first year, increasing at a 3% rate over the ten-year economic life of the project.The new line would be depreciated using five-year MACRS (Year 1: 20%; Year 2: 30%; Year 3: 20%; Year4: 12%; Year 5: 12% and Year 6: 6% - rounded percentages). At the end of the ten-year project life,Rogers would have to pay $40,000 to remove the new model.The existing assembly line originally cost $150,000 eleven years ago. It has been depreciated on thestraight-line basis over fifteen years to a zero salvage value for income tax purposes. It could be soldtoday for $25,000 or operated for ten additional years, at which time it would cost $24,000 to remove.Rogers, Inc., is subject to an average corporate income tax rate of 28% and a marginal income tax rate of30% and uses a 15% after-tax cost of capital to evaluate investment proposals.Required:Clearly identify the after-tax cash flows at time 0, times 1 through 10, and time 10*. It might be easier touse the tax shield approach and consider the present values of the (a) and (b) components over the projects’lives. Determine the Net Present Value of the replacement proposal. Should Rogers replace the existingassembly line?

Answer 1

Particulars	0	1	2	3	4	5	6	7	8	9	10
Cost Saving Growth			3%	3%	3%	3%	3%	3%	3%	3%	3%
Depreciation		20%	30%	20%	12%	12%	6%
Tax Rate	30%
Kc	15%
Old Machinery
Orignal Life	15
Period Old	11
Orignal Cost	150000
Book Value	40000
Selling Value	25000
Loss on sale	15000	(It is Tax Deductible, therefore can be Setoff Later)
Cash Outflows
Price	500000
Installation cost	50000
Cost to be Capitalised	550000
Employee Training Cost	35000	(It is Tax Deductible, therefore can be Setoff Later)
Total Loss to be Setoff	50000
Total Cash Outflow	560000
Cash Inflows
Cost Savings		120000	123600	127308	131127.2	135061.1	139112.9	143286	147585	152012	156573
Add: Saving of cost of Removal (old)											24000
Less: Depreciation		110000	165000	110000	66000	66000	33000
Less: Cost Of removal (New)											40000
Earning Before Tax		10000	-41400	17308	65127.24	69061.06	106112.9	143286	147585	152012	140573
Less: Last year Loss Setoff		10000	0	17308	64092
Taxable Earning		0	-41400	0	1035.24	69061.06	106112.9	143286	147585	152012	140573
Less: Tax		0	0	0	310.572	20718.32	31833.87	42986	44275	45603.7	42171.8
Earning After Tax		10000	-41400	17308	724.668	48342.74	74279.02	100300	103309	106409	98400.9
Net Cash inflow		120000	123600	127308	66724.67	114342.7	107279	100300	103309	106409	98400.9
PV Factor		0.86957	0.756144	0.65752	0.571753	0.497177	0.432328	0.3759	0.3269	0.28426	0.24718
Present Value		104348	93459.36	83707.1	38150.05	56848.55	46379.68	37707	33772	30248	24323.2
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