Question

Salamanca, Inc. plans to purchase new equipment for its manufacturing plant. Salamanca plans to purchase the equipment for a total cost of $900,000. The equipment will be depreciated to zero over 5 years. Granada expects that the new equipment will have no impact on its sales revenue. However, Salamanca expects that its current annual fixed costs of $10,000,000 will be reduced by 3% annually as a result of using this new equipment.    Salamanca’s tax rate is 30%. What operating cash flow (OCF) should Salamanca use in year 3 in its capital budgeting analysis if the project is expected to last 5 years?

Answer 1

Cost of Equipment = $900,000

Life = 5 years

Depreciation per year = 180,000

Annual reduction in fixed cost = 10,000,000*3% = 300,000

Tax on reduced cost = 90,000

Net Savings in fixed Cost = $210,000

Savings in tax on depreciation = 180,000*30% = $54,000

Net Annual Benefit = $264,000

Operating cash flow (OCF) Salamanca should use in year 3 in its capital budgeting analysis             = $264,000

Cost of asset (equipment) will be outflow at year 0