Fleming Company is considering an investment is a machine that would reduce annu
ID: 2558573 • Letter: F
Question
Fleming Company is considering an investment is a machine that would reduce annual labor costs by $30,000. The machine has an expected life of 10 years with no salvage value. The machine would be depreciated according to the straight-line method over its useful life. The company-'s marginal tax rate is 30%. 26. Refer to Fleming Company. Assume the company will invest in the machine if it generates an internal rate of return of 16%, what is the maximum amount the company can pay and still meet the internal rate of return criterion? a. $180,000 b. $210,000 c. $187,500 d. $144,996Explanation / Answer
From buying the new machine, the company will get the following benefits:
(a) Saving in annual labor cost by $30,000 pre tax
(b) Tax benefit of 30% of annual depreciation amount
Now let's assume the total cost of the machine is 'X'. The annual depreciation shall be 1/10th of 'X', since the company will depreciate the cost of machine in 10 years on Straight line method.
Total annual post tax savings from the machine shall be derived as under:
(1-tax rate) x Savings in annual labor cost + Annual depreciation x tax rate
= (1-30%) * $30,000 + (1/10) * X * 30%
=0.7*$30,000 + 0.03X
=$21,000 + 0.03X
The above saving shall be derived every year till 10years. The internal rate of return of the company is 16%. Lets assume that all the savings from the machine shall arrive at the end of the year. We shall calculate the Present value of the annuity for 10years @ 16% interest rate.
PV of annuity of $1 @16% p.a. for 10 years = 4.83323 (The same can be calculated using excel tool PV formula)
The company can pay the maximum amount for the machine equal to the present value of the benefits to be received from the machine i.e.
Maximum cost for the machine = PV of the post tax annual benefits from the machine
X = 4.83323*($21,000 + 0.03X)
i.e. X = $101,497.83 + 0.145X
i.e. (X - 0.145X) = $101,497.83
i.e. 0.855 X = $ 101,497.83
i.e. X = $101,497.73/0.855 = $118,710.80
Hence, the company can pay maximum amount of $118,710.80 say $118,700 for the machine. None of the options (a,b,c,d) is correct in the given problem.
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