Two used machines can be acquired for $60,000 per machine to provide necessary s
ID: 2788463 • Letter: T
Question
Two used machines can be acquired for $60,000 per machine to provide necessary service for the next 2 years. The salvage of these machines is estimated at $20,000 per machine at the end of year 2 when the old machines will be replaced with one new machine capable of providing the same total service. The new machine would cost 350,000 at the end of year two and is anticipated to yield a salvage value of $170,000 at the end of year 4 when the service will no longer be required. Operating costs associated the used machines are estimated at $60,000 per machine at year 1 and $70,000 per machine at year 2. Operating costs with a new machine purchased at year 2 are estimated to be $80,000 at year 3 and $85,000 at year 4. Instead of buying the old machines and replacing them at year 2, a new machine providing necessary service can be purchased today (time 0) for a cost of $300,000. Service with either the old or new machines is needed for the next 4 years; therefore, a 4-year evaluation life should be used. It is estimated that a new machine purchased at time 0 will yield a salvage value of $80,000 at year 4. Operating costs with a new machine purchased now (time 0) are estimated at $75,000 at year 1, $80,000 at year 2, $85,000 at year 3, and $90,000 at year 4. Assuming a minimum discount rate of 15%, use after-tax net present value analysis of each alternative to determine the least cost approach for providing the necessary service. The effective state and federal income tax rate is 40% and other income assumed to exist against which to utilize all deductions. Any gain on salvage is taxed as ordinary income. All assets represent 5-year depreciable property. Use straight-line method.Explanation / Answer
Alternative 1 - two used machines and 1 used machine
Old Machines
Depreciation per year on each old machine = $60000 / 5 = $12000
Depreciation Tax shield = $12000 x 40% = $4800
Total depreciation each year for first two years = $12000 x 2 = $24000
Book value of each machine at the end of 2nd year = $60000 - $24000 = $36000
Tax shield on loss on sale on each machine = ($36000 - $20000) x 40% = $6400
New Machine
Depreciation per year = $350000 / 5 = $70000
Depreciation Tax shield each year = $70000 x 40% = $28000
Total depreciation each year for first two years = $70000 x 2 = $140000
Book value of each machine at the end of 2nd year = $350000 - $140000 = $210000
Tax shield on loss on sale on each machine = ($210000 - $170000) x 40% = $16000
(-)$163000
(Inflow)
Total Present Value of Cash Outflows = $375,198.55
Alternative 2 - One new machine
Depreciation per year = $300000 / 5 = $60000
Depreciation Tax shield per year = $60000 x 40% = $24000
Book value after 4 years = $300000 - $60000 x 4 = $60000
Tax on Profit on sale = ($75000 - $60000) x 40% = $6000
Salvage value net of tax = $75000 - $6000 = $69000
0.869565
Total Present Value of Cash Outflows = $331,862.88
So, Alternative 2 is better as it has less cost.
Present Value of Cash Outflows Particulars Year 0 Year 1 Year 2 Year 3 Year 4 Initial Cost of Machine $60000 x 2 = $120000 $350000 Operating Costs (net of tax) $60000 x 2 x (1 - 0.40) = $72000 $70000 x 2 x (1 - 0.40) = $84000 $80000 x (1 - 0.40) = $48000 $85000 x (1 - 0.40) = $51000 Less: Depreciation Tax shield $4800 x 2 = $9600 $4800 x 2 = $9600 $28000 $28000 Less: Salvage Value $20000 x 2 = $40000 $170000 Less: Tax shield on Loss $6400 x 2 = $12800 $16000 Total Cash Outflows $120000 $62400 $371600 $20000(-)$163000
(Inflow)
PVF@ 15% 1 0.869565 0.756144 0.657516 0.571753 Present Value $120000 $54260.86 $280983.11 $13150.32 (-)$93195.74Related Questions
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