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$ (19,000)

carryforward of operating loss

(19,500)

0

0 (S,oO)

Operating loss carryforward

0

0 $ 5,500

0

Taxable income

Income tax on income from

$2,200

0

0

0

operations (40%)

Income tax from sale of mall

40,000

operation

$ 42,200

Total income taxes

Total cash flows before taxes

$249,000

$29,500 $44,000

$( 145,ooO)

(part 1)

42,200

0

0

0

Less: Income taxes

$206,800

$29,500 $44900

$( 145,000)

Total cash flows after taxes

__ ˜

*S-Y-D depreciation calculation:

$130,000

Purchase price of equipment

20,000

Salvage value

Depreciable base

249

CAPITAL BUDGETING (INCLUDING LEASING)

CHAP. 81

Year Depreciation

Rate

10155 $20,000

19x6

19x7 18,000

9/55

8/55

19x8 16,000

7/55

19x9 14,000

Determination of Cash Flows. The Norman Corporation of Cerritos, CA, maker of a famous

8.33

electronic component, is considering replacing one of its current hand-operated assembly

machines with a new fully automated machine. This replacement would mean the elimination of

one employee, generating salary and benefit savings.

One full-time machine operator - salary and benefits, $25,000 per year

Keep:

Cost of maintenance - $2000 per year

Cost of defects - $6000

Original depreciable value of old Machine - $50,000

Annual depreciation - $5000 per year

Expected life - 10 years

Age - 5 years old

No expected salvage value in 5 years

Current salvage value - $5000

Tax rate - 34 percent

Cost of new machine - $60,000

Replace:

Installation fee - $3000

Transportation charge - $3000

Cost of maintenance - $3000 per year

Cost of defects - $3000 per year

Expected life - 5 years

Salvage value - $20,000

Depreciation method by straight-line

1. Given the following information, determine the cash flows associated with this

replacement.

2. Assume an after-tax cost of capital of 14 percent, compute:

( a ) Payback period

(6) Internal rate of return

(c) Net present value

Should the new machine be bought?

SOLUTION

1. (1) The initial outlay:

outflows:

Cost of machine $60,000

Installation fee 3,000

Shipping fee 3,000

Inflows:

Salvage value - old machine -5,000

Tax savings on sale of old

machine ($25,OOO-$5,000)

(0.34) -6,800

$54,200

250 CAPITAL BUDGETING (INCLUDING LEASING) [CHAP 8

(2) The differential cash flows over the project's life.

Book Cash

Income Flow

Savings: Reduced salary $25,000 $25,000

Reduced defects 3,000

3,000

(o

Lw

Costs: Increased maintenance (1,000)

Increased depreciation

($13,200-$5000)"

Net savings before taxes $27,000

Taxes (0.34) (6,392)

Annual net cash flow after taxes $20,608

+ $3,0()0)/5= $13,200.

*Annual depreciation on the new machine = ($60,000+ $3,o(x)

(3) The terminal cash flow:

Salvage value - new machine $20,000

Less: Taxes on gain: 6,800

($20,000 - 0) X 0.34

$13,200

Thus, the cash flow in the final year will be equal to the annual net cash flow in that year of

$20,608 plus the terminal cash flow of $13,200 for a total of $33,808.

2. (a) Payback period $54,200/$20,608= 2.63 years

=

(6) IRR by trial and error = about 30 percent

$54,200 = $20,608 PVIFAj.5 + $13,200 PVIFj.5

+

(c) NPV = $20,608 PVIFA14%,,5 $13,200 PVIF14U/o,S- $54,200

= $20,608 (3.433) + $13,200 (0.519) - $54,200

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