The Quick Manufacturing Company, a large profitable corporation, is considering

Question

The Quick Manufacturing Company, a large profitable corporation, is considering the replacement of a production machine tool. A new machine would cost $3700, have a 4-year useful and depreciable life, and have no salvage value. For tax purposes, sum- of-years'-digits depreciation would be used. The existing machine tool was purchased 4 years ago at a cost of $4000 and has been depreciated by straight-line depreciation assuming an 8-year life and no salvage value. The tool could be sold now to a used equipment dealer for $1000 or be kept in service for another 4 years. It would then have no salvage value. The new machine tool would save about $900 per year in operating costs compared to the existing machine. Assume a 40% combined state and federal tax rate.

Explanation / Answer

Initial outflow:

Cost of new machine 3700

less: salvage of old tool (1000)

2700

less:loss on sale of tool(1000-1110) (110)

less: tax on loss on sale($110*40%) (44)

Net outflow $2546

Note:- Book value of old tool = $4000 - Depreciaiton(upto 4 years]

= 4000 - (889 + 778+667+556)

     =$4000 - $2890

   = $1110

Sum of digit depreciation:

year Useful life sum of year digit Annual Depreciation

1 8 8/36 4000 *8/36 = $889

2 7 7/36 4000*7/36 = $778

3 6 6/36 4000*6/36 =$667

4 5 5/36 4000*5/36 =$556

5 4 4/36 4000*4/36 =$444

6 3 3/36 4000*3/36 = $333

7 2 2/36 4000*2/36 = $222

8   1    1/36 4000*1/36 = $111

36

Net annual cash inflow per year:

saving in operating cost =$900

less: Depreciaiton =($925)

profit before tax = (25)

less: tax 40% = (10)

profit after tax =(35)

add: depreciation = 925

Net annual cash inflow =$890

Note:- Depreciation of new machine per year = $3700/4year

= $925

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