Question

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 $20,000 in 3 years. The new equipment has a purchase price of $100,000 and is also considered a 5-year class for MACRS. Installation costs for the new equipment are $7,000. The estimated salvage value of the new equipment is $70,000. This new equipment is more efficient than the existing one and thus savings before taxes using the new equipment are $17,000 a year. Due to these savings, inventories will see a one time reduction of $2,000 at the time of replacement. The company's marginal tax rate is 30% and the cost of capital is 12%. For this project, what is the incremental cash flow in year 1?

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%

Answer 1

Solution:-

Incremental cash flow in year 1

Step 1 calculation of After-tax savings using new equipment

After-tax savings using new equipment = before tax savings using new equipment * (1- Tax-rate)

where,

before tax savings using new equipment = $17000

tax- rate = 30%

After-tax savings using new equipment = $17000 *(1-.3)

=$11900

Step 2 calculation of increase in depreciation tax shield

a).Depreciation of new equipment in year 1 = Net cost of machine * Depreciation rate

Net cost of machine = cost of purchase + installation cost

= $100000 + $7000

=$107000

Depreciation rate = 20%

  Depreciation of new equipment in year 1 = $107000 * 20%

= $21400

b).Depreciation of old equipment in year 1 = Net cost of machine * Depreciation rate

Net cost of machine = cost of purchase + installation cost

= $40000 + $8000

=$48000

Depreciation rate = 19.20% (3rd year in the life of old machine)

  Depreciation of old equipment in year 1 = $48000 * 19.20%

= $9216

increase in depreciation =  depreciation of new equipment- depreciation of old equipment

By substituting the values we get,

  increase in depreciation = $21400 - $9216

= $12184

incremental tax-shield =  increase in depreciation * tax rate

=$12184 * .3

=$3655.2

finally,

Incremental cash flow in year 1 = After-tax savings using new equipment + incremental depreciation tax shield

by substituting the values we get,

Incremental cash flow in year 1 = $11900 + $3655.2

= $15555.5