Question

HL Construction Co. plans to replace one of its manufacturing equipment for a newer more technology-advance one. The new equipment has a purchase price of $8,000 and will be depreciated as a 7-year class for MACRS. Installation costs for the new equipment are $200. It is estimated that this equipment can be sold in 5 years (end of project) for $5,000. This new equipment is more efficient than the existing one and thus savings before taxes using the new equipment are $4,000 a year. Because of the advance technology of new equipment, there will be a reduction in inventory of $400 today and which will be reverted at the end of the project in year 5.

This existing equipment was purchased 1 year ago at a base price of $3,000. Installation costs at the time for this old equipment were $100. The existing equipment is considered also 7-year class for MACRS. The existing equipment can be sold today for $1,000 and for $0 in 5 years. The company's marginal tax rate is 30% and the cost of capital is 10%.

Answer the 7 questions below.

MACRS Fixed Annual Expense Percentages by Recovery Class
Year	3-Year	5-Year	7-Year	10-Year	15-Year
1	33.33%	20.00%	14.29%	10.00%	5.00%
2	44.45%	32.00%	24.49%	18.00%	9.50%
3	14.81%	19.20%	17.49%	14.40%	8.55%
4	7.41%	11.52%	12.49%	11.52%	7.70%
5		11.52%	8.93%	9.22%	6.93%
6		5.76%	8.93%	7.37%	6.23%
7			8.93%	6.55%	5.90%
8			4.45%	6.55%	5.90%
9				6.56%	5.91%
10				6.55%	5.90%
11				3.28%	5.91%
12					5.90%
13					5.91%
14					5.90%
15					5.91%
16					2.95%

For your answer, round to the nearest dollar, do not enter the $ sign, use commas to separate thousands, use a negative sign in front of first number is the cash flow is 10.30

negative (do not use parenthesis to indicate negative cash flows). For example, if your answer is $3,005.87 then enter 3,006; if your answer is -$1,200.25 then enter -1,200

5. What is the cash flow due to tax on salvage value of new equipment at Year 5? If this is a cash outflow put the negative sign (-) in front of the value ** do not use parentheses. If it is a cash inflow, then just enter the number

6. What is the after tax salvage value of the new equipment at Year 5?

7. What is the project's total incremental cash flow for Year 5?

Answer 1

Written down value of equipment at the end of Year 5 = Purchase cost – Accumulated depreciation

= 8200*(100-14.29-24.49-17.49-12.49-8.93)%

= $1097.16

Selling price = $5000

Gain on sale = $3902.84

Tax on gain = 3902.84*30% = $1170.852

Hence, cash flow due to tax on salvage value of new equipment at Year 5 = -$1171

6. After tax salvage value = 5000-1171

= $3829

7.Total incremental cash flow = (Savings before taxes – Depreciation)(1-Tax rate) + Depreciation + After tax salvage value – Recovery of working capital

= (4000-732.26)(1-30%)+ 732.26 + 3829 – 400

= $6448.678

i.e. $6449