A proposed cost-saving device has an installed cost of $640,000. The device will

Question

A proposed cost-saving device has an installed cost of $640,000. The device will be used in a five-year project but is classified as three-year MACRS property for tax purposes. The required initial net working capital investment is $46,000, the marginal tax rate is 30 percent, and the project discount rate is 8 percent. The device has an estimated year 5 salvage value of $71,000. What level of pretax cost savings do we require for this project to be profitable? Refer to Table 10.7. (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))

Explanation / Answer

Cost of the device = $ 640000

Salvage Value = $ 71000

Depreciable Value = 640000 - 71000 = $ 569000

The present value of cash flows during the life of the asset should be the minimum cost saving required to enable the project to be profitable.

The difference in cash flow comes to $ 459274.37. This is the minimum amount of post tax cost savings required. the required pre tax cost savings = 459274.37 / (1-0.30) = $ 656106.24

Note:

Tax rate is 30%. hence it is considered as 0.30. If 459274.37 is after tax that is 70%, then pre tax is 459274.37 / 0.7 (1 - 0.3)

Depreciation is calculated assuming that the income tax depreciation rate is as per the table provided for the three year property class.

The depreciable value is applied with the relevant rates in the table to arrive at the depreciation

Year Particulars Cash Flow PV Factor @ 8% Present Value 0 Initial Cost (640000) 1 (640000) 0 Working Capital (46000) 1 (46000) 1 Tax Savings on Depreciation 56894.31 0.9259 52679.92 2 Tax Savings on Depreciation 75876.15 0.8573 65051.57 3 Tax Savings on Depreciation 25280.67 0.7938 20068.61 4 Tax Savings on Depreciation 12648.87 0.7350 9297.30 5 Salvage Value 71000 0.6806 48321.41 5 release of Working Capital 46000 0.6806 31306.83 Net Balance (459274.37)

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