Mom’s Cookies, Inc., is considering the purchase of a new cookie oven. The origi

Question

Mom’s Cookies, Inc., is considering the purchase of a new cookie oven. The original cost of the old oven was $46,000; it is now five years old, and it has a current market value of $20,500. The old oven is being depreciated over a 10-year life toward a zero estimated salvage value on a straight-line basis, resulting in a current book value of $23,000 and an annual depreciation expense of $4,600. The old oven can be used for six more years but has no market value after its depreciable life is over. Management is contemplating the purchase of a new oven whose cost is $26,000 and whose estimated salvage value is zero. Expected before-tax cash savings from the new oven are $3,300 a year over its full MACRS depreciable life. Depreciation is computed using MACRS over a 5-year life, and the cost of capital is 10 percent. Assume a 35 percent tax rate.

What will the cash flows for this project be? (Note that the $46,000 cost of the old oven is depreciated over ten years at $4,600 per year. The half-year convention is not used for the old oven. Negative amounts should be indicated by a minus sign. Do not round intermediate calculations and round your answers to 2 decimal places.)

Mom’s Cookies, Inc., is considering the purchase of a new cookie oven. The original cost of the old oven was $46,000; it is now five years old, and it has a current market value of $20,500. The old oven is being depreciated over a 10-year life toward a zero estimated salvage value on a straight-line basis, resulting in a current book value of $23,000 and an annual depreciation expense of $4,600. The old oven can be used for six more years but has no market value after its depreciable life is over. Management is contemplating the purchase of a new oven whose cost is $26,000 and whose estimated salvage value is zero. Expected before-tax cash savings from the new oven are $3,300 a year over its full MACRS depreciable life. Depreciation is computed using MACRS over a 5-year life, and the cost of capital is 10 percent. Assume a 35 percent tax rate.

Explanation / Answer

1) Initial Investment outlay New Oven Cost -$26,000 Market value of old Oven $20,500 Tax Saving sale of old Oven (calculated below) $875 Total Net Investment -$4,625 Book value of old oven at end of 5 years = $46,000 - ($4600 x 5) $23,000 Tax saving sale of old oven = (Market Value - book value) x Tax Rate= ($23000 - $20500) x 35% $875 2) Incremental Operating Cash Flow 0 1 2 3 4 5 6 Expected before-tax cash savings new oven $3,300 $3,300 $3,300 $3,300 $3,300 $3,300 After Tax cash savings new oven = Expected cash saving x (1 - 35%) $2,145 $2,145 $2,145 $2,145 $2,145 $2,145 MACRS over a 5-year life 20.00% 32.00% 19.00% 12.00% 11.00% 6.00% New Oven Depreciation ($26,000 x MACRS Rate) $5,200 $8,320 $4,940 $3,120 $2,860 $1,560 Old Oven Depreciation $4,600 $4,600 $4,600 $4,600 $4,600 $0 Change in Depreciation $600 $3,720 $340 -$1,480 -$1,740 $1,560 Tax Saving from Depreciation = change in dep. x 35% $210 $1,302 $119 -$518 -$609 $546 Net operating cash flow = After tax saving new oven + Tax saving from dep. $2,355 $3,447 $2,264 $1,627 $1,536 $2,691 Salvage Value 0 Free cash Flow -$4,625 $2,355 $3,447 $2,264 $1,627 $1,536 $2,691

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