5-STAR INC. purchased $120K of factory production equipment. It was depreciated

Question

5-STAR INC. purchased $120K of factory production equipment. It was depreciated utilizing the SOYD depreciation method, a 5-year life, and no salvage value. 5-STAR INC. is profitable and has a 34% incremental tax rate. At the end of 5 years, 5-STAR INC. changed its factory operation and sold the equipment for $40K. In the 5-year use period for the equipment, 5-STAR INC. saw a net benefit of $32K per year, before taxes. If 5-STAR INC’s MARR is 12% after taxes, was the investment a sound investment for them?

Explanation / Answer

Working notes:

(1) MACRS Depreciation schedule

(2) At end of 5 years,

Book value of asset = Purchase price - Total depreciation = $(120,000 - 113,088) = $6,912

(3) Gain on asset sale = Sale price - Book value = $(40,000 - 6,912) = $33,088

(4) Pre-tax Net benefit (NB) = Net benefit - Annual depreciation

(4) Pre-tax NB, years 1-4 = $32,000 - Annual depreciation

Pre-tax NB, year 5 = $(32,000 + 33,088 - Annual depreciation) = $65,088 - Annual depreciation,

Assuming gain on sale of asset is taxable.

(5) Post-tax NB = Pre-tax NB x (1 - tax rate) = Pre-tax NB x (1 - 0.34) = Pre-tax NB x 0.66

(6) Cash flow after tax (CFAT) = Post-tax NB + Depreciation

**CFAT in year 0 = Purchase price of asset = $120,000

(7) Discount factor (DF) is computed at 12%.

(8) NPV is sum of Discounted CFAT (DCFAT).

Since NPV is negative, the investment should not be undertaken.

Year Depreciation base ($) Depreciation % Annual depreciation ($) (1) (2) (3) = (1) x (2) 1 1,20,000 20 24,000 2 1,20,000 32 38,400 3 1,20,000 19.2 23,040 4 1,20,000 11.52 13,824 5 1,20,000 11.52 13,824 TOTAL 1,13,088

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