A company has purchased equipment (for $49,000) that will reduce materials and l

Question

A company has purchased equipment (for $49,000) that will reduce materials and labor costs by $13,000 each year for N years. After N years, there will be no further need for the machine, and because the machine is specially designed, it will have no MV at any time. The IRS, however, has ruled that the company must depreciate the equipment on a SL basis with a tax life of five years. If the effective income tax rate is 36%, what is the minimum number of years the company must operate the equipment to eam 1 1% per year after taxes on its investment? years to earn 11% per year after taxes on its Your irm must operate the equipment for minimum investment. (Round to the nearest whole number.) Enter your answer in the answer box. 5/2 arch

Explanation / Answer

Here, the required minimum post tax return at 11% on investment of $ 49,000 = Investment * required return = 49000 * 11% = $ 5,390

Now let us calculate per annum after tax profit, in order to do so we first need to calculate per annum depreciation using SLM method, Depreciation per annum = (Cost of equipment - salvage value) / Useful life for tax purposes = (49000 - 0) / 5 = $ 9800 per annum.

Per annum after tax profit = (Cash inflow - Depreciation) - tax = (13000-9800) - 36% = $ 2048

Thus the company earns $ 2048 post tax each year, so in order to reach upto the required return of $5390, the company will operate the equipment for 1 year + 1 year i.e. earning 2048+2048 = $ 4096, to earn additional 1294 dollars, the company will have to operate for (1294/2048) = 0.6318 years

This makes the total period to be = 1 + 1 + 0.6318 = 2.6318 years

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