Question

1. Tank Ltd is considering undertaking the purchase of a new piece of equipment that is expected to increase revenue by $12,000 each year for six years. The equipment will increase costs $4,000 each year for six years. It costs $32,000 to purchase today and for tax purposes must be depreciated down to zero over its 8 year useful life using the straight-line method. If Tank is actually forecasting a salvage (for capital budgeting purposes) of $5,000 after 6 years, what is the machine's net cash flow (after tax) for year 6? Assume the tax rate is 30%.

   A,13000 B, 11800 C, 12400 D, 12700

Answer 1

The incremental revenues and costs associated with the new equipment are as follows:

Incremental annual revenue = $12,000

Incremental annual cost = $4,000

Incremental annual operating profit pre-depreciation = Incremental revenue - Incremental cost = $12,000 - $4,000 = $8,000

As the equipment is likely to be depreciated to $0 from its initial value of $32,000 over a period of 8 years using the straight line method of depreciation, the annual depreciation amount can be calculated as = $32,000/8 = $4,000 per year

Thus, Incremental Profit before tax = Incremental annual operating pre-depreciation - Depreciation = $8,000 - $4,000 = $4,000

Since the tax rate is given as 30%, the incremental Profit after tax = Incremental profit before tax * (1-Tax rate)

= $4,000 * (1 - 0.3) = $2,800

Since depreciation is a non-cash expense, the annual operating cashflow = incremental profit after tax + depreciation = $2,800 + $4,000 = $6,800

Further, since Tank Ltd plans to sell of the equipment at the end of 6th year at a salvage value of $5,000, the machine's net cashflow (after tax) for year 6 = Annual operating cashflow + Salvage value = $6,800 + $5,000 = $11,800

Thus the answer is B. $11,800