Question

1. Annadark Corp is considering the purchase of a machine that costs $1,300,000. The machine will be depreciated using a five year MACRS schedule with half-year convention (Refer to the MACRS Schedule handout). Annadark plans to sell the machine after four years and expects the sale price at that time to be $540,000. Corporate tax rate of 21% applies to Annadark. This machine is expected to add $450,000 in revenue each year. a. What will be the depreciation on the machine for each of the six years? b. What will be the book value of the machine at the end of four years? c. What will be the after tax salvage value of the machine, if the tax rate is 21%? BONUS: Annadark also has the option of leasing the machine for a total after-tax cost of $198,000 per year. Should Annadark lease the machine or purchase the machine if its after-tax cost for long term borrowing is 3.4%?

Answer 1

Ans. Depreciation for 6 years give below

Book value of machine at end of 4th year = $224,640

After tax salvage value of machine = $473,774

Since NPV of $927,818 of leasing the machine is higher than NPV of $608,547 of buying the machine. Hence Annadark Corp should lease the machine for $198,000

	0	1	2	3	4	5	6
Machine value	1,300,000
Depreciation rate as per MACRS		20.0%	32.0%	19.2%	11.5%	11.5%	5.8%
Depreciation		-260,000	-416,000	-249,600	-149,760	-149,760	-74,880
Book value of machine		1,040,000	624,000	374,400	224,640	74,880	0
Sale price at end of 4th year					540,000
Profit on the machine (sale price - book value)					315,360
Tax at 21%					-66,226
After tax salvage value of machine					473,774
	0	1	2	3	4
Revenue from machine		450,000	450,000	450,000	450,000
Interest cost on borrowings		-44,200	-44,200	-44,200	-44,200
After interest revenue		405,800	405,800	405,800	405,800
Cost of machine	-1,300,000
After tax salvage value					473,774
Net cash flow	-1,300,000	405,800	405,800	405,800	879,574
Discount factor at 3.4%	1.000	0.967	0.935	0.905	0.875
Present value of cash flow	-1,300,000	392,456	379,552	367,071	769,468
NPV					608,547
If leasing the machine	0	1	2	3	4
Revenue from machine		450,000	450,000	450,000	450,000
After tax cost		-198000	-198000	-198000	-198000
Net cash flow		252,000	252,000	252,000	252,000
Discount factor at 3.4%		0.967	0.935	0.905	0.875
Present value of cash flow		243,714	235,700	227,950	220,454
NPV					927,818

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