2. A highly specialized piece of equipment has a first cost of $50,000. If this
ID: 2570258 • Letter: 2
Question
2. A highly specialized piece of equipment has a first cost of $50,000. If this equipment is purchased, it will be used to produce income (through rental) of $20,000 per year for only four years. Estimated annual expenses for upkeep are $3,000 per year during each of the four years. The MACRS (GDS) recovery period for the equipment is seven years and the effective income tax rate is 40%. The firm’s after-tax MARR is 7% per year. a. Assume that the equipment is placed on standby status after four years of service such that the depreciation is taken over the full MACRS recovery period. Since the equipment is on standby status the BTCF will be zero after the fourth year of use. However, a DWO can still be taken on the equipment until it is fully depreciated. Use a PW analysis and determine if the equipment should be purchased. b. Assume that the equipment will be donated to a university after its fourth year of use. The depreciation deduction in year four will be reduced by 50% due to the half-year convention. The remaining book value will be considered as a negative taxable income in year four thus providing additional tax relief in year four. The Instructor suggests that you separate the computations for these two items in your tabulation. Use a PW analysis and determine if the equipment should be purchased.2. A highly specialized piece of equipment has a first cost of $50,000. If this equipment is purchased, it will be used to produce income (through rental) of $20,000 per year for only four years. Estimated annual expenses for upkeep are $3,000 per year during each of the four years. The MACRS (GDS) recovery period for the equipment is seven years and the effective income tax rate is 40%. The firm’s after-tax MARR is 7% per year. a. Assume that the equipment is placed on standby status after four years of service such that the depreciation is taken over the full MACRS recovery period. Since the equipment is on standby status the BTCF will be zero after the fourth year of use. However, a DWO can still be taken on the equipment until it is fully depreciated. Use a PW analysis and determine if the equipment should be purchased. b. Assume that the equipment will be donated to a university after its fourth year of use. The depreciation deduction in year four will be reduced by 50% due to the half-year convention. The remaining book value will be considered as a negative taxable income in year four thus providing additional tax relief in year four. The Instructor suggests that you separate the computations for these two items in your tabulation. Use a PW analysis and determine if the equipment should be purchased.
a. Assume that the equipment is placed on standby status after four years of service such that the depreciation is taken over the full MACRS recovery period. Since the equipment is on standby status the BTCF will be zero after the fourth year of use. However, a DWO can still be taken on the equipment until it is fully depreciated. Use a PW analysis and determine if the equipment should be purchased. b. Assume that the equipment will be donated to a university after its fourth year of use. The depreciation deduction in year four will be reduced by 50% due to the half-year convention. The remaining book value will be considered as a negative taxable income in year four thus providing additional tax relief in year four. The Instructor suggests that you separate the computations for these two items in your tabulation. Use a PW analysis and determine if the equipment should be purchased.
Explanation / Answer
a. Calculation of Net Cash flows from Purchasing the equipment
Particulars
Amount (In $)
(A)
Time(n)
Present Value Factor (1/ (1.07)n), i=7%
(B)
Present Value Amount (In $)
(A x B)
Cash Outflows:
Purchase of equipment
50,000
0
1
50,000
TOTAL CASH OUTFLOWS
50,000
Rental Income
17,000
1-4
3.387 (Cumulative Present Value factor)
57,579
Tax Savings on Depreciation:
Tax saved on Depreciation expense for 1st year
50,000 x 14.29%
1
0.9345
6,677
Tax saved on Depreciation expense for 2nd year
50,000 x 24.40%
2
0.8734
10,655.48
Tax saved on Depreciation expense for 3rd year
50,000 x 17.49%
3
0.8163
7,138.54
Tax saved on Depreciation expense for 4th year
50,000 x 12.49%
4
0.7629
4764.31
Tax saved on Depreciation expense for 5th year
50,000 x 8.93%
5
0.713
3,183.545
Tax saved on Depreciation expense for 6th year
50,000 x 8.92%
6
0.6663
2971.70
Tax saved on Depreciation expense for 7th year
50,000 x 8.93%
7
0.6227
2,780.355
Tax saved on Depreciation expense for 8th year
50,000 x 4.46%
8
0.582
1,297.86
TOTAL TAX SAVINGS
39,468.79 x 40% = 15,787.516
Total Cash Savings/ Inflows
=57,579 + 15787.52 = $73,366.52
Net Present Value
23,366.52
Since the Net Present Value of Cash flows is positive, the equipment should be purchased.
Particulars
Amount (In $)
(A)
Time(n)
Present Value Factor (1/ (1.07)n), i=7%
(B)
Present Value Amount (In $)
(A x B)
Cash Outflows:
Purchase of equipment
50,000
0
1
50,000
TOTAL CASH OUTFLOWS
50,000
Rental Income
17,000
1-4
3.387 (Cumulative Present Value factor)
57,579
Tax Savings on Depreciation:
Tax saved on Depreciation expense for 1st year
50,000 x 14.29%
1
0.9345
6,677
Tax saved on Depreciation expense for 2nd year
50,000 x 24.40%
2
0.8734
10,655.48
Tax saved on Depreciation expense for 3rd year
50,000 x 17.49%
3
0.8163
7,138.54
Tax saved on Depreciation expense for 4th year
50,000 x 12.49%
4
0.7629
4764.31
Tax saved on Depreciation expense for 5th year
50,000 x 8.93%
5
0.713
3,183.545
Tax saved on Depreciation expense for 6th year
50,000 x 8.92%
6
0.6663
2971.70
Tax saved on Depreciation expense for 7th year
50,000 x 8.93%
7
0.6227
2,780.355
Tax saved on Depreciation expense for 8th year
50,000 x 4.46%
8
0.582
1,297.86
TOTAL TAX SAVINGS
39,468.79 x 40% = 15,787.516
Total Cash Savings/ Inflows
=57,579 + 15787.52 = $73,366.52
Net Present Value
23,366.52
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