This is a sample question so I have the answer but I need to know the method of

Question

This is a sample question so I have the answer but I need to know the method of getting to the answer. I am not getting to the correct number. Please give detailed very simplified explanation using a financial calculator, calculator or Excel spreadsheet so that I understand how to do this please.

Your company is considering the replacement of an old delivery van with a new one that is more efficient. The old van cost $30,000 when purchased 5 years ago and is being depreciated using the simplified straight line method over a useful life of 10 years. The old van could be sold for $5,000 today. The new van has an invoice price of $75,000 and will cost an additional $5,000 to modify it to carry the company's products. Cost savings from the use of the new van are expected to be $22,000 per year for 5 years at which time the van will be sold for its estimated salvage value of $15,000. The new van will be depreciated using the simplified straight line method over its 5 year useful life. The company's tax rate is 35%/ Working capital is expected to increase by $3,000 at the inception of the project, but this amount will be recaptured at the end of year five. What is the tax effect of selling the old machine?

Please help! Thanks

Explanation / Answer

The Old Van was valued at $30,000 but was depreciated over a 10 year span to zero. Because only 5 years have passed the van has not been fully depreciated. Since annual depreciation expense is $30000/10 years or $3000 per year we can figure out that in 5 years, $15000 worth of depreciation has taken place, reducing the book value of the van from $30000 to $15000. Now we sell that van for $5000. As you can see we are selling it below book value and hence are incurring a loss. That loss is (Salvage Value - Accounting Book Value) or -$10000. Multiply by the 35% tax rate and this is a TAX CREDIT which will reduce future taxes. Our new van is going to generate those taxes with additional profits. We will purchase the van for $80,000 (75,000 + 5,000 to modify) and it will be depreciated over 5 years to zero. That means depreciation expense of $16,000 per year. Savings - depreciation = Profit before taxes or $22,000 - $16,000 = $6000 per year. Taxes on this will be $2,100 per year for 5 years, or $10,500. Finally, we will sell the second van for $15,000 but after it has been depreciated to zero. Again, Salvage - Accounting Book Value = Taxable Value of Asset. This is $15,000 - $0 = $15,000. This gain must be taxed at 35% or $5,250. Thus we have three effects on taxes. First, we get a tax credit of $3,500 for selling the first van below book value. Second, we owe $2,100 from profits on periods 1-5 on the new van. Third, we owe $5,250 on the second van for selling it above its book value. Final effect on taxes is $10,500 + $5,250 - $3,500 = $12,250. Hope this helps!

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