Question

Mom’s Cookies, Inc., is considering the purchase of a new cookie oven. The original cost of the old oven was $42,000; it is now five years old, and it has a current market value of $18,500. The old oven is being depreciated over a 10-year life toward a zero estimated salvage value on a straight-line basis, resulting in a current book value of $21,000 and an annual depreciation expense of $4,200. The old oven can be used for six more years but has no market value after its depreciable life is over. Management is contemplating the purchase of a new oven whose cost is $25,000 and whose estimated salvage value is zero. Expected before-tax cash savings from the new oven are $3,700 a year over its full MACRS depreciable life. Depreciation is computed using MACRS over a 5-year life, and the cost of capital is 10 percent. Assume a 34 percent tax rate.

What will the cash flows for this project be? (Note that the $42,000 cost of the old oven is depreciated over ten years at $4,200 per year. The half-year convention is not used for the old oven. Negative amounts should be indicated by a minus sign. Do not round intermediate calculations and round your answers to 2 decimal places.)

Answer 1

Calculation of cash flows of the project
Year		0	1	2	3	4	5	6
Investment in new oven		-$25,000.00
After tax sale value of old oven		$19,350.00
Before tax cash savings			$3,700.00	$3,700.00	$3,700.00	$3,700.00	$3,700.00	$3,700.00
Tax @ 34% on cash savings			-$1,258.00	-$1,258.00	-$1,258.00	-$1,258.00	-$1,258.00	-$1,258.00
Depreciation tax shield			$272.00	$1,292.00	$204.00	-$448.80	-$448.80	$489.60
Cash flows of project		-$5,650.00	$2,714.00	$3,734.00	$2,646.00	$1,993.20	$1,993.20	$2,931.60
Working
Calculation of depreciation on New Oven using 5 Year MACRS rates
Year	Depreciable value	Depreciation rates	Depreciation
1	$25,000.00	20%	$5,000.00
2	$25,000.00	32%	$8,000.00
3	$25,000.00	19.20%	$4,800.00
4	$25,000.00	11.52%	$2,880.00
5	$25,000.00	11.52%	$2,880.00
6	$25,000.00	5.76%	$1,440.00
Calculation of additional depreciation and depreciation tax shield on additional depreciation
Year	Depreciation - New Oven	Depreciation - Old Oven	Additional depreciation	Tax shield @ 34%
1	$5,000.00	$4,200.00	$800.00	$272.00
2	$8,000.00	$4,200.00	$3,800.00	$1,292.00
3	$4,800.00	$4,200.00	$600.00	$204.00
4	$2,880.00	$4,200.00	-$1,320.00	-$448.80
5	$2,880.00	$4,200.00	-$1,320.00	-$448.80
6	$1,440.00		$1,440.00	$489.60
Calculation of after tax sale value of old oven
Sale value of old oven		$18,500.00
Less : Book value		$21,000.00
Loss on sale		-$2,500.00
Tax benefit @ 34% of loss		$850.00
After tax sale value of old oven		$19,350.00