Question

Rockyford Company must replace some machinery that has zero book value and a current market value of $2,800. One possibility is to invest in new machinery costing $50,000. This new machinery would produce estimated annual pretax cash operating savings of $20,000. Assume the new machine will have a useful life of four years and depreciation of $12,500 each year for book and tax purposes. It will have no salvage value at the end of four years. The investment in this new machinery would require an additional $4,000 investment of net working capital. (Assume that when the old machine was purchased the incremental net working capital required at the time was $0.)

     If Rockyford accepts this investment proposal, the disposal of the old machinery and the investment in the new one will occur on December 31 of this year. The cash flows from the investment will occur during the next four calendar years.

     Rockyford is subject to a 40% income-tax rate for all ordinary income and capital gains and has a 9% weighted-average after-tax cost of capital. All operating and tax cash flows are assumed to occur at year-end. (For Parts 2 and 3, use the relevant table from Appendix C–Table 1 or Table 2.)

Required:

1.	Determine the after-tax cash flow arising from disposing of the old machinery.

      

2.	Determine the present value of the after-tax cash flows for the next four years attributable to the cash operating savings. (Round your answer to the nearest whole dollar amount.)

      

3.	Determine the present value of the tax shield effect of depreciation for year 1. (Round your answer to the nearest whole dollar amount.)

      

4.

Which one of the following is the proper treatment for the additional $4,000 of net working capital required in the current year?

	It should be ignored in capital budgeting because it is not a capital investment.
	It is a sunk cost that needs no consideration in capital budgeting.
	It should be treated as part of the initial investment when determining the net present value.
	It should be spread over the machinery’s four-year life as a cash outflow in each of the years.
	It should be included as part of the cost of the new machine and depreciated.

Answer 1

Solution 1:

After tax cash flow from disposing old machine = $2,800 (1-0.40) = $1,680

Solution 2:

Annual pretax operating cash savings = $20,000

Annual after tax operating cash savings = $20,000 (1-0.40) = $12,000

Present value of after tax cash flows attributable to cash operating savings = $12,000 * cumulative PV Factor at 9% for 4 periods

= $12,000 * 3.23972 = $38,877

Solution 3:

Depreciation for year 1 = $12,500

Tax shield on depreciation = $12,500 * 40% = $5,000

Present value of the tax shield effect of depreciation for year 1 = $5,000 * PV factor at 9% for 1st period

= $5,000 * 0.917431 = $4,587

Solution 4:

Additional $4,000 of net working capital required in current year will be treated as part of the initial investment when determining the net present value.

Hence 3rd option is correct.