An analyst has been asked by the president of Ellis Construction Company to eval

Question

An analyst has been asked by the president of Ellis Construction Company to evaluate the proposed acquisition of a new earthmover. The mover's basic price is $50,000, and it will cost another $10,000 to modify it for special use by Ellis Construction. Assume that the mover falls into the MACRS 3-year class. See table for recovery allowance percentages. It will be sold after 3 years for $20,000, and it will require an increase in working capital (spare parts inventory) of $2,000. The earthmover purchase will have no effect on revenues, but it is expected to save Ellis $20,000 per year in before-tax operating costs, mainly labor. Ellis's marginal federal-plus-state tax rate is 40 percent.
Recovery Allowance Percentage
Year 3-Year
1 33%
2 45%
3 15%
4 7%


What is the company's net investment if it acquires the earthmover? (That is, what are the Year 0 cash flows?)
A. $58,000.
B. $60,000
C. $50,000.
D. $62,000.

Explanation / Answer

Correct answer: D Cash Flow1 =0-(-20,000)(1-.4) + (.33)(60,000)(.4) = 12,000 + 7920 = 19,920 Cash Flow2 =0-(-20,000)(1-.4) + (.45)(60,000)(.4) = 12,000 + 10,800 = 22,800 Cash Flow3 =0-(-20,000)(1-.4) + (.15)(60,000)(.4) = 12,000 + 3600 = 15,600

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