Taylor United is considering overhauling its equipment to meet increased demand

Question

Taylor United is considering overhauling its equipment to meet increased demand for its product. The cost of equipment overhaul is $3.8 million, plus $200,000 in installation costs. The firm will depreciate the equipment modifications under MACRS using a five-year recovery period. Additional sales revenue from the overhaul should amount to $2.2 million per year, and additional operating expenses and other costs (excluding depreciation) will amount to 35 percent of the additional sales. The firm has an ordinary tax rate of 40 percent. Answer the following questions about Taylor United, for each of the next six years.

a. What additional earnings, before depreciation and taxes, will result from the overhaul?

b. What additional earnings after taxes will result from the overhaul?

c. What incremental operating cash flows will result from the overhaul?

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Explanation / Answer

a)additional earnings, before depreciation and taxes =2.2 million - 35%*2.2 million = $1.43 million

b)Depreciation in 1st year = 20%*(3.8 +.20) = 0.8 milion

additional earnings after taxes = (1.43 - 0.8)*(1-40%) = 0.378 million

c)operating cash flows == (1.43 - 0.8)*(1-40%) +0.8=$1.178 million

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