Question

Top-Ten Inc. is considering replacing its existing machine that is used to produce musical CDs. This existing machine was purchase 3 years ago at a base price of $50,000. Installation costs at the time for the machine were $1,000. The existing machine is considered a 3-year class for MACRS. The existing machine can be sold today for $30,000 and for $10,000 in 3 years. The new machine has a purchase price of $90,000 and is also considered a 3-year class for MACRS. Installation costs for the new machine are $8,000. The estimated salvage value of the new machine is $20,000. This new machine is more efficient than the existing one and thus savings before taxes using the new machine are $7,000 a year. 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%

Answer 1

Answer : Incremental Cash Flow = Savings Before Tax - ( Tax on Savings ) + Depreciation Tax Shield

Given Savings = 7000

Calculation of Depreciation Tax Shield using 3 year Recovery Rate :

Depreciation on New Machine = 33.33% * (Purchase Price + Installation)

= 33.33% * (90000 + 8000)

= 32663.40

Depreciation on Old Machine = 7.41% * (Purchase Price + Installation)

= 7.41 % * (50000 + 1000)

= 3779.10

Note : Since for Old machine it is Fourth year from purcahse therefore we have used Fourth year Depreciation Rate.

Additional Depreciation = 32663.40 - 3779.10

= 28884.30

Tax Sield on Depreciation = 28884.30 * 30%

= 8665.29

Incremental Cash Flow = 7000 - ( 7000 * 30%) + 8665.29

= 7000 - 2100 + 8665.29

= $13565.29

$13565.29 is incremental Cash flow for year 1 .