Determining the depreciation schedule


Part 1: High Tech Production Inc. purchased a computerized measuring device two years ago for $80,000. This equipment falls into the five-year category for MACRS depreciation. The equipment can currently be sold for $28,400. A new piece of equipment will cost $210,000 that would replace the exisitng equipment. It also falls into the five-year category for MACRS depreciation. It is anticipated this new piece of equipment will be sold at the end of the 5th year of operation for a price of $20,000. The tax rate is 34 percent and the cost of capital is 12 percent.

The new equipment would provide the following stream of operating cost savings before depreciation and taxes for the next five years.

Year Cost Savings
1    $76,000
2    66,000
3    62,000
4    60,000
5    56,000

a. Determine the depreciation schedule for the old equipment.
b. What is the book value of the old equipment?
c. What is the tax gain or loss on the sale of the old equipment?
d. What is the tax or the tax benefit from the sale?
e. What is the cash inflow from the sale of the old equipment?
f. What is the net cost of the new equipment? (Include the inflow from the sale of the old equipment.)
g. Determine the depreciation schedule for the new equipment.
h. What will be the book value of the new piece of equipment when it comes time to sell it, and what will be the tax gain or loss on the sale of the new equipment?
i. What will be the tax or the tax benefit from the sale and the net cash inflow from the sale of the new equipment?
j. What is the present value of the net cash inflow from the salvage of the new equipment?
k. Determine the incremental depreciation between the new equipment the remaining years of the old equipment, and the related tax shield benefits.
l. Compute the after-tax benefits of the cost savings.
m. Add the depreciation tax shield benefits and the after-tax cost savings, and determine the present value of these incremental benefits.
n. Compare the present value of the incremental benefits (m), plus the present value of the expected proceeds from the salvage of the new machine (j) with the net cost of the new machine (f).
o. Should the replacement be undertaken?

Part 2:  Work out and submit the comprehensive problem below.

Halstrom Corporation purchased a piece of equipment three years ago for $230,000. It has an asset depreciation range (ADR) midpoint of eight years. This equipment can be sold now for $90,000.

A new piece of equipment can be purchased for $320,000 that would replace the existing equipment. It also has an ADR of eight years.
The new equipment, if purchased, will have a useful life of six years, with no salvage value at the end of that time. If the old equipment is kept, it will be operated for six more years in addition to the three years it has already been operated. It also will have no salvage value at the end of that time.

The old and new equipment would provide the following operating gains or losses (earnings before depreciation, interest, and taxes) over the next six years, beginning with the coming year.

Table:

Year New Equipment    Old Equipment
1 (1st year of new equip., 4th year of old equip.)    $80,000    $25,000
2    76,000    16,000
3    70,000    9,000
4    60,000    8,000
5    50,000    6,000
6    45,000    (7,000)

The firm has a 36 percent tax rate and a 9 percent cost of capital. Do the calculations to determine if the new equipment should be purchased to replace the old equipment. Should the new equipment be purchased or should the old equipment be kept in operation?
Be careful here. This problem involves an investment that is supposed to increase profits, whereas the problem in Part 1 involved investing in a machine that would result in a cost savings. While the cash benefit resulting from the purchase of new equipment can come either in the form of a cost savings or an increase in profit, in this case be careful to work with the increase in cash flows resulting from the purchase of the new machine, not merely the profit from the new machine. The fact that the new machine will earn some profit is not sufficient reason to invest in it. It must increase profits enough to justify its purchase. This is easily seen if we consider a case where the new machine will in fact earn a profit, but the profit will actually be less than the existing machine is presently earning. Clearly, one would not purchase such a machine to replace the existing one. It is the increase in cash flows that counts.

Part 3: Work out and submit the following comprehensive problem.

As you checked the Answer Key to Question in the Mastery Check from this lesson you may have noted that each year's net cash flows are calculated by adding depreciation back to net earnings:

Jayhawk Company has a proposed contract with the Comprehensive Systems of Kansas. The initial investment in land and equipment will be $120,000. Of this amount, $70,000 is subject to five-year MACRS depreciation. The balance is in non-depreciable property. The contract covers six years. At the end of six years, the non-depreciable assets will be sold for $50,000. The depreciated assets will have zero resale value.

The contract will require an investment of $55,000 in working capital at the beginning of the first year, and, of this amount, $25,000 will be returned to the Jayhawk Technology Company after six years.

The investment will produce $50,000 in income before depreciation and taxes for each of the six years. The corporation is in a 40 percent tax bracket and has a 10 percent cost of capital.

Using a piece of paper or a computer spread sheet, determine whether or not the investment should be undertaken. Use the net present value method.

Year 0    Year 1    Year 2    Year 3    Year 4    Year 5    Year 6
EBIDT    50,000    50,000    50,000    50,000    50,000    50,000
Depreciation    14,000    22,400    13,440    8,050    8,050    4,060
Earnings before taxes    36,000    27,600    36,560    41,950    41,950    45,940
Taxes    14,400    11,040    14,624    16,780    16,780    18,376
Earnings after taxes    21,600    16,560    21,936    25,170    25,170    27,564
Depreciation    14,000    22,400    13,440    8,050    8,050    4,060
Cash flow    35,600    38,960    35,376    33,220    33,220    31,624
Investment    -120,000    50,000
Net work capital    -55,000    25,000
-175,000    106,624

NPV = 19,564 @ 10% cost of capital (The answer is $19,643 with a financial calculator.)

On the other hand, the problem in Part 1 of this assignment specifies a series of steps that leads you through the same approach as that used in the answer key for Question 8 in the Mastery Check of this lesson:

Part 4: The Acme Corporation is considering the purchase of an additional lathe to handle periodic overload conditions in the shop. By reducing overtime premiums, purchase of this lathe will result in cash savings of $20,000 per year before taxes. The new lathe would cost $50,000 and would be depreciated using 5 year MACRS. However, it is anticipated that it would be sold at the end of 5 years for an estimated $15,000.

Using a piece of paper or a computer spreadsheet, calculate the after-tax cash flows for this investment proposal using the method described in the discussion material for this lesson. (That is, calculate the after-tax cash flows as if there were no non-cash expenses.) Then adjust these after-tax cash flows for the tax credits resulting from the non-cash tax shields. Calculate the net present value of this investment proposal using a 15% discount rate. Acme's marginal tax rate is 40%.

Year 0    Year 1    Year 2    Year3    Year 4    Year5
EBIDT    20,000    20,000    20,000    20,000    20,000
(1) After tax @ 40% tax rate    12,000    12,000    12,000    12,000    12,000
Depreciation    10,000    16,000    9,600    5,750    5,750
(2) Depreciation tax credit    4,000    6,400    3,840    2,300    2,300
Yearly cash flow (1) + (2)    16,000    18,400    15,840    14,300    14,300
Investment/salvage    -50,000    10,160
Total cash flow    -50,000    16,000    18,400    15,840    14,300    24,460
NPV = $8,589.34 @ 15% cost of capital. (Answer is $8,578.16 with a financial calculator)
Depreciation and Book Value
Year    0    1    2    3    4    5
Depreciation percent    0.200 0.320 0.192 0.115    0.115
Depreciation    10000 16000    9600    5750    5750
Remaining book value    40000 24000    14400    8650    2900

Sale price    15000
Book value    2900
Taxable profit on sale    12100
Tax on profit on sale    4840
Net proceeds from sale    10160

Rework and submit Question 6 using the same approach to calculate each year's after-tax cash flows as is used to solve

That is, calculate the after-tax cash flows as if there were no non-cash expenses. Then, adjust these after-tax cash flows for the tax credits resulting from the non-cash tax shields. (This is the method the problem in Part 1 leads you through as you follow the specified steps a through o for solving that problem).

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