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18. Immediate disposal of an old machine usually results in that is fully deductible

from current income for tax purposes.

19. The FASB requires firms to certain financial (capital) leases and to restate their

20. Lease payments represent a desired rate of return to the

21. If two mutually exclusive projects have unequal lives, either of the two methods may be used for

the analysis: the and the

22. The overcomes many of the IRRâ€™s disadvantages.

(1) cost (purchase price) of the asset, the proceeds from sale of the old asset, taxes on the sale of old

Answers:

asset; (2) a capital gain, recapture of depreciation, different; (3) depreciation; (4) discounted cash flow (DCF); (5)

Capital budgeting, long-term investment; (6) Payback period, initial amount of investment; (7) payback period,

liquidity; (8) time value of money; (9) present value of cash inflows, the initial investment; (10) the cost of capital;

(11) not even; (12) mutually exclusive investments, conflicting rankings; (13) Profitability index (or benefitkost

ratio); (14) NPV, cost of capital; (15) useful life; (16) Investment tax credit (ITC); (17) the half-year convention,

first; (18) a loss; (19) capitalize, balance sheets; (20) lessor; (21) replacement chain (common life) approach,

equivalent annual annuity (EAA); (22) modified internal rate of return (MIRR).

[CHAP 8

220 CAPITAL BUDGETING (INCLUDING LEASING)

Solved Problems

Capital Gain (Loss) and Recapture of Depreciation. For each of the following cases, compute

8.1

the total taxes resulting from the sale of the asset. Assume a 34 percent ordinary tax rate. The

asset was purchased for $75,000 3 years ago and has a book value (undepreciated value) of

$40,000. ( a ) The asset is sold for $80,000. ( b )The asset is sold for $70,000. (c) The asset is sold

for $40,000, ( d ) The asset is sold for $38,000.

SOLUTION

Total gain = selling price - book value

= $80,000 - $4O,OOO = $40,000

Total taxes are: $13,600 (34% X $4O,OoO)

$70,000 - $40,000 = $30,000

(6) Gain:

$30,000 X 0.34 = $10,200

Tax:

( c ) No tax.

$38,000 - $40,000 = $2,000

( d ) Loss:

$2,000 X 0.34 = $680

Tax saving:

Calculation of Initial Investment. A firm is considering replacing an old machine with another.

8.2

The new machine costs $90,000plus $10,000 to install. For each of the four cases given in Problem

8.1, calculate the initial investment of the replacement.

SOLUTION

(4

(4 (d

(6)

Cost of new machine $90,000

$90,000 $9O,oOo

$90,000

+ Installation cost 10,000 10,Ooo 10,000

10,000

- Proceeds from sale of old machine 70,000 38,000

80,000 40,000

0

+ Taxes on sale of old machine 17,500 13,800 0

$61,080

$43,800 $60,000

$37,500

Initial investment

Incremental Cash Inflows. National Bottles Corporation is contemplating the replacement of one

8.3

of its bottling machines with a new one that will increase revenue from $25,000 to $31,000 per

year and reduce cash operating costs from $12,000 to $lO,OOOper year. The new machine will cost

$48,000 and have an estimated life of 10 years with no salvage value. The fr uses straight-line

im

depreciation and is subject to a 46 percent tax rate. The old machine has been fully depreciated

and has no salvage value. What is the incremental (relevant) cash inflows generated by the

replacement?

SOLUTION

cost

Annual depreciation of the new machine =

expected life

- $48â€™000

--= $4,800 per year

10

221

CAPITAL BUDGETING (INCLUDING LEASING)

CHAR 81

Annual

Net Profits before

Depreciation and Taxes

Revenue Cash Operating Costs

$25,000 $12,000

Old $13,000

$31,000 $10,000

New $21,000

Net profits after taxes and after-tax cash inflows for both machines are computed as follows:

APtepTax

Net Profits after Taxes Cash Mows

Add Depredation

($13,000 - 0)(1 - 0.46) = $7,020 $ 0 $ 7,020

Old

($21,000- $4,800)(1- 0.46) = $8,748 $4,800 $13,548

New

Therefore, the relevant incremental cash inflows for each year are:

$13,548 - $7,020 = $6,528

Alternatively, use the shortcut formula, as follows:

Increase in revenue x (1 - tax rate):

($31,000 - $25,000)(1- 0.46) $3,240

- Increase in cash charges X (1 - tax rate):

-(- 1,080)

($lO,OOO - $12,000)(1- 0.46)

+ Increase in depreciation X tax rate:

($4,800 - 0)(0.46) 2,208

$6,528

After-tax cash inflows

Basic Evaluation Methods. The following data are given for the Alright Aluminum Company:

8.4

Initial cost of proposed equipment $75,000

7 years

Estimated useful life

Estimated annual savings in cash operating expenses $18,OOo

Predicted residual value at the end of the useful life $3,000

Cost of capital 12%

Compute the: ( a )payback period; (b) present value of estimated annual savings; (c) present value

of estimated residual value; (d) total present value of estimated cash inflows; (e) net present value

(NPV); and (f) internal rate of return (IRR).

SOLUTION

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