A division of a large corporation is considering the purchase of a new tunneling

Question

A division of a large corporation is considering the purchase of a new tunneling X-ray microscope for $370,125. The projected net benefits from gains in materials engineering is projected to be $125,000 in today’s real dollars for the first year, increasing by an arithmetic gradient of $18,500 per year in real dollars for years 2 to 4. The unit will be depreciated under MACRS. Due to increasing advances in tunneling X-ray microscope technology, the unit will have $50,000 market value in today’s real dollars at the end of the 4 year project life. During the 4 year analysis period, inflation is expected to be steady at 3.8% per year. The corporation has a combined state and federal income tax rate of 40.0%. The corporation requires a 15.0% after-tax market rate of return on its research and development investments. Should the X-ray unit be purchased?

Explanation / Answer

Working notes:

(1) MACRS depreciation schedule:

(It is assumed that the equipment falls under MACRS 5-year property class).

(2) Pre-tax net benefit (NB), year 5 = Annual pre-tax net benefit + $50,000 (Salvage)

(It is assumed that salvage value is taxable at normal rate)

(3) Pre-tax Gain = Pre-tax NB - Annual depreciation

(It is assumed that the stated Net benefits exclude the effect of depreciation)

(3) Post-tax gain = Pre-tax gain x (1 - Tax rate) = Pre-tax gain x 0.6

(4) After-tax cash flow (ATCF) = After-tax gain + Depreciation (Being non-cash expense, it is added back)

(5) Real discount rate = Nominal return - inflation rate = (15 - 3.8)% = 11.2%

(S0, discounte factor (DF) is at 11.2%).

(6) NPV = Sum of all real cash inflows and outflows discounted at 11.2%

(7) Relaxation/change in assumptions made will result in different NPV.

Since NPV is positive, the X-ray unit should be purchased.

Year Depreciation base ($) Depreciation rate (%) Annual depreciation ($) (A) (B) (C) = (A) x (B) 1 3,70,125 20 74,025 2 3,70,125 32 1,18,440 3 3,70,125 19.2 71,064 4 3,70,125 11.52 42,638

Related Questions

Navigate

• Browse (All)
• Browse A
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.