Big-Pear Corp. is considering replacing its existing equipment that is used to produce smart cell phones. This existing equipment was purchase 3 years ago at a base price of $40,000. Installation costs at the time for the machine were $6,000. The existing equipment is considered a 5-year class for MACRS. The existing equipment can be sold today for $60,000 and for $20,000 in 3 years. The new equipment has a purchase price of $150,000 and is also considered a 5-year class for MACRS. Installation costs for the new equipment are $8,000. The estimated salvage value of the new equipment is $70,000. This new equipment is more efficient than the existing one and thus savings before taxes using the new equipment are $11,000 a year. Due to these savings, inventories will see a one time reduction of $3,000 at the time of replacement. The company's marginal tax rate is 30% and the cost of capital is 12%. For this project, what is the incremental cash flow in year 1?
| 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% | ||||
Incremental cash flow in year 1 =
Savings before taxes ( 1- tax rate ) + Incremental depreciation * tax rate
Where, Incremental depreciation =Depreciation for new equipment - Depreciation for existing equipment
And we know that , Depreciation on new equipment = (Base price + Installation cost)* MACRS depreciation rate for year 1 based on 5 year class and Depreciation for existing equipment = (Base price+ Installation cost)*MACRS Depreciation rate for year 4 based on 5 year class
Hence , Incremental depreciation =
(150,000+8,000)*20% - (40,000+6,000)*11.52%
=$26,300.80
Hence , Incremental cash flow in year 1 =
11,000*0.70 + 26,300.80*0.30
=$15,590.24
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