Question

The Clampton Company is considering the purchase of a new machine to perform operations currently being performed on different, less efficient equipment. The purchase price is $180,000, delivered and installed. A Clampton production engineer estimates that the new equipment will produce savings of $45,000 in labor and other direct costs annually, compared with the present equipment. He estimates the proposed equipment’s economic life at five years, with zero salvage value. The present equipment is in good working order and will last, physically, for at least ten more years. The company requires a return of at least 8 percent before taxes on an investment of this type. Taxes are to be disregarded.

Changing machines in a world with taxes

Assume that the Clampton Company in the previous question expects to pay income taxes of 35 percent and that a loss on the sale or disposal of equipment is treated as an ordinary deduction, resulting in a tax savings of 35 percent. The Clampton Company wants to earn 6 percent on its investment after taxes. Depreciation for tax purposes is computed on the straight-line method.

A. Should the company buy the equipment if the facts are otherwise as described in first scenerio from the previous question?

B. Should the company buy the equipment if the facts are otherwise as described in the second scenerio from the previous question?

Please show your work

Answer 1

A.Without Taxes:

Evaluation of new machinery

Year	Cash Flows	PVF@8%	PV
0	-180000	1	-180000
1-5	45000	3.99	179550
		Net Benefit	-450

The company should not buy the equipment because of negative incremental cash flows

B.With Taxes:

Year	Cash Flows	PVF@6%	PV
0	-180000	1	-180000
1-5 Savings in Direct Cost	45000(1-.35)=29250	4.21	123143
1-5 Savings in Tax on Depreciation	36000*35%=12600	4.21	53046
		Net Benefit	-3811

The Company should not buy the equipment because of negative incremental cash flows

Note: Profit/Loss on sale of existing asset has been ignored, since no information is available