Q23. You are analyzing the purchase of new equipment. Since you are not an exper
ID: 2738991 • Letter: Q
Question
Q23. You are analyzing the purchase of new equipment. Since you are not an expert on this type of equipment, you hire a consulting firm to make recommendations. The consultant charged you $1,500 and recommended the purchase of the latest model from ACME Corp. of America. The equipment costs $80,000, and it will cost another $10,000 to modify it for special use by your firm. The equipment will be depreciated on a straight-line basis over six years with no salvage value. You expect the equipment will be sold after three years for $28,000. Use of the equipment will require an increase in your company's net working capital of $4,000, but this $4,000 will be recovered at the end of year three. The use of the equipment will have no effect on revenues, but it is expected to save the firm $50,000 per year in before-tax operating costs. Your company's marginal tax rate is 35%. What is the terminal cash flow for this project?
a. $17,000
b. $24,500
c. $33,950
d. $37,950
Explanation / Answer
After tax terminal cash flow of the project is the total of the after tax sale proceeds of the equipment and the release of net working capital invested at the inception of the project.
Cost of equipment = $80,000 + $10,000 = $90,000
Annual depreciation = $90,000/6 years = $15,000
Depreciation charges up to the end of year three = $15,000 * 3 = $45,000
Book value of the equipment at the end of year 3 = $90,000 - $45,000 = $45,000
Sale value of the equipment = $28,000
Loss on sale of equipment = $45,000 - $28,000 = $17,000
Tax savings on sale of machine = $17,000 * 35% = $5,950
Sale proceeds of equipment = Sale value of equipment + Tax savings on sale of machine = $28,000 + $5,950 = $33,950
Release of net working capital investment = $4,000
Terminal cash flows of project = $33,950 + $4,000 = $37,950
Hence, answer is d. $37,950
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