3. Your firm plans to purchase a manufacturing machine which costs $500,000 from

Question

3. Your firm plans to purchase a manufacturing machine which costs $500,000 from a local manufacturer. This machine has straight line depreciation period of 8 years. However, you were told that if you buy the same machine from a manufacturer from Alaska, the U.S. tax authorities will allow you an accelerated straight line depreciation period of 4 years. You also know that in the latter case you will have to pay additional shipping costs of $15,000 (payable today). . Assuming your firm's tax rate is 30%, and the discount rate is 12%, from which manufacturer should you buy the machine? What is the maximal shipping cost at which you'll be indifferent between the manufacturers (assuming that shipping cost cannot be considered for depreciation purpose)? Answer without using Excel's function 'Goal Seek' or 'Solver Hint: you need to consider the tax benefit of depreciation for these two different choices. Tax benefit related to depreciation is called a tax shield of depreciation." Put it more straightforward, if your firm has a tax rate of 30%, for every $100 depreciation, this will save you $30 taxes. tidntion and make one can be updated

Explanation / Answer

If we purchase the asset from local manufacturer at $500,000 we will depreciate it equally over 8 years, so that means our annual depreciation will be 500,000/8 = $62,500. If we purchase the asset from Alaska manufacturer at $500,000 plus 15,000 shipping we will depreciate it equally over 4 years, so that means our annual depreciation will be 515,000/4 = $128,750. Normal depreciation period (local) Year 1 2 3 4 5 6 7 8 Annual depreciation 62,500 62,500 62,500 62,500 62,500 62,500 62,500 62,500 Annual tax shield from depreciation         18,750         18,750         18,750         18,750           18,750        18,750        18,750        18,750 Normal depreciation period Alaska) Year 1 2 3 4 5 6 7 8 Annual depreciation 128,750 128,750 128,750 128,750 0 0 0 0 Annual tax shield from depreciation         38,625         38,625         38,625         38,625                   -                   -                   -                   -   Differential cash flow         19,875         19,875         19,875         19,875         (18,750)       (18,750)       (18,750)       (18,750) NPV @12% required rate of return 17,745.54 15,844.23 14,146.63 12,630.92 (10,639.25) (9,499.33) (8,481.55) (7,572.81) Additional value including shipping cost     2,745.54 15,844.23 14,146.63 12,630.92 (10,639.25) (9,499.33) (8,481.55) (7,572.81) Net Gain from using machine from Alaska will be     9,174.37 Maximal shipping cost will be that cost which will be the Net gain from these two method in Present value terms Normal depreciation period (local) Year 1 2 3 4 5 6 7 8 Annual depreciation 62,500 62,500 62,500 62,500 62,500 62,500 62,500 62,500 Annual tax shield from depreciation         18,750         18,750         18,750         18,750           18,750        18,750        18,750        18,750 Normal depreciation period Alaska) Year 1 2 3 4 5 6 7 8 Annual depreciation (500,000/4) not including shipping cost 125,000 125,000 125,000 125,000 0 0 0 0 Annual tax shield from depreciation         37,500         37,500         37,500         37,500                   -                   -                   -                   -   Differential cash flow         18,750         18,750         18,750         18,750         (18,750)       (18,750)       (18,750)       (18,750) NPV @12% required rate of return 16,741.07 14,947.39 13,345.88 11,915.96 (10,639.25) (9,499.33) (8,481.55) (7,572.81) Net Gain from using machine from Alaska will be 20,757.35 So, at shipping cost of 20,757.25, both the option will be neutral

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