Question

XYZ Company’s machine was purchased 5 years ago for $55,000. It had an expected life of 10 years when it was bought, and its remaining depreciation is $5,500 per year for each year of its remaining life and can be sold for $20,000 at the end of its useful life. A new machine can be purchased for $120,000, including the installation costs. During its 5-year life, it will reduce cash operating expenses by $30,000 per year. Sales revenue will not be affected. At the end of its useful life, the machine is estimated to be sold at $10,000. We will use MARCS depreciation, and the machine will be depreciated over its 5-year property class life. The old machine can be sold today for $35,000.

*The tax rate is 25%

*WACC is 16%

a) what is the amount of the initial cash flow at Year 0 if the new machine is purchased?

b)Calculate the after-tax salvage value of the new machine at the end of the project?

c)Calculate the incremental cash flows that will occur at the end of years 1-5?

*Use excel cell reference for the questions for the above questions

Answer 1

a) Amount of initial cash flow if new machine is purchased at year 0 would be as follows:

By purchasing the new machine we would incur $120000. But if we purchase the new machine we would sell the old machine that will result in inflow of $35000. But this value is greater than the old machine's book value which is $ 55000 less 5 years depreciation which will come out to be (55000/10) i.e. 5500 per year and 5 years depreciation should be 5500 x 5 = 27500. It means the value of the machine after 5 years should be 55000 less 27500 = 27500.

But we are selling it for 35000, which means we have to pay tax on the extra inflows i.e. 35000 less 27500 = 7500 x 25% tax = 1875. so the net inflow would be 35000 less 1875 = 33125.

So the amount of initial cash flow will be 120000 less 33125 = $ 86875 outflow

b) After tax salvage value of new machine would be as follows:

The new machine was purchased for $120000 and it has a useful life of 5 years, which means it would be depreciated for $ 24000 per year (120000 / 5). So at the end of its useful life it should have a book value equal to zero, but we are estimating to be selling it for $ 10000. So after tax salvage value of the new machine would be 10000 less 25% tax = $ 7500

c) To compute the incremental cash flows we would be using the following formula

(Incremental sales - incremental cost ) (1 - tax rate) + incremental depreciation x tax rate.

So the incremental cash flows that will occur at y=end of year 1 through 5 would be as follows:

Year 1 = (0 - (-30000)) (1 - 0.25) + (24000 - 5500) x 0.25 = $ 27125.

Year 2 = (0 - (-30000)) (1 - 0.25) + (24000 - 5500) x 0.25 = $ 27125

Year 3 = (0 - (-30000)) (1 - 0.25) + (24000 - 5500) x 0.25 = $ 27125

Year 4 = (0 - (-30000)) (1 - 0.25) + (24000 - 5500) x 0.25 = $ 27125

Year 5 = (0 - (-30000)) (1 - 0.25) + (24000 - 5500) x 0.25 = $ 27125

As it can be seen from the above functions that the new machine has saved incremental cost of $ 30000, but it should be taken after tax. Similarly incremental depreciation multiplied by tax also results in tax savings.