Question

The Target Copy Company is contemplating the replacement of its old printing machine with a new model costing $ 715. The new machine will operate for 3 years and then project will be shut down and all equipment sold. The old machine, which originally cost $ 518, has 2 years of depreciation remaining and a current book value of 22% of the original cost. The old machine has a current market value of $ 268 and should be worth $ 204 at the end of 3 years. The new printing machine could be sold for $ 319 in 3 years. If we buy the new machine our inventory levels will go from $600 to $900. Inventory levels will return to normal at the end of the project. Our annual sales will go from $15,000 to $20,000. Target's corporate tax rate is 25 percent. Both machines are in the 3-year MACRS class, with rates of 33% for year 1, 45% for year 2, 15% for year 3, and 7% for year 4. What are the expected Terminal Cash Flows at the end of year 3, if we replace the old printing machine?

Answer 1

The expected Terminal (Non operating) Cash Flows at the end of year 3, if we replace the old printing machine will be made up of:

• Post tax salvage value of new machine:
  • Sale value at the end of 3 years = $ 319
  • Tax basis after three years = undepreciated portion = 7.41% (pending depreciation at the end of year 3 under 3 years MACRS schedule) x $ 715 = 52.9815
  • Gain on sale = 319 - 52.9815 = 266.02
  • Tax rate = T = 25%
  • Tax on gain on sale = T x Gain on sale = 25% x 266.02 = $ 66.50
  • Post tax salvage value of new machine = Sale value - tax on gain on sale = 319 - 66.50 = $ 252.50
• Release of working capital invested = 900 - 600 = $ 300
• Post tax salvage value on old machine lost = Sale value - tax on sale value (as the old machine would have been fully depreciated by then, so entire sale value will be gain) = 204 - 204 x 25% = $ 153

The expected Terminal (Non operating) Cash Flows at the end of year 3, if we replace the old printing machine = 252.50 + 300 - 153 = $ 399.50