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

		0	1	2	3	4	5	6
a)	Depreciation %		20.00	32.00	19.20	11.52	11.52	5.76
	Depreciation expense		$ 2,60,000	$   4,16,000	$ 2,49,600	$    1,49,760	$   1,49,760	$       74,880
b)	Accumulated depreciation		$ 2,60,000	$   6,76,000	$ 9,25,600	$ 10,75,360	$12,25,120	$ 13,00,000
	Book value at EOY 4 = 1300000-1075360 =					$    2,24,640
c)	Salvage value					$    5,40,000	`
	Gain on sale = 540000-224640 =					$    3,15,360
	Tax on gain at 21%					$       66,226
	After tax salvage value = 540000-66226 =					$    4,73,774
d)	Tax shield on depreciation at 21%		$     54,600	$       87,360	$     52,416	$       31,450
	After tax cash flows of buying	-1300000	$     54,600	$       87,360	$     52,416	$    5,05,224
	PVIF at 3.4%	1	0.96712	0.93532	0.90456	0.87482
	PV at 3.4%	$   -13,00,000	$     52,805	$       81,709	$     47,414	$    4,41,979
	NPV of buying	$     -6,76,093
	NPV of leasing = -198000*(1.034^4-1)/(0.034*1.034^4) =	$     -7,28,999
	Net advantage of leasing [NAL]	$         -52,906
	As NAL is negative, the firm should buy the machine.
	NOTE:
	The annual revenue is not considered as it is the same for both the alternatives.