Question

Dungan Corporation is evaluating a proposal to purchase a new drill press to replace a less efficient machine presently in use. The cost of the new equipment at time 0, including delivery and installation, is $265,000. If it is purchased, Dungan will incur costs of $7,600 to remove the present equipment and revamp its facilities. This $7,600 is tax deductible at time 0.

Depreciation for tax purposes will be allowed as follows: year 1, $66,000; year 2, $96,000; and in each of years 3 through 5, $56,000 per year. The existing equipment has a book and tax value of $126,000 and a remaining useful life of 10 years. However, the existing equipment can be sold for only $66,000 and is being depreciated for book and tax purposes using the straight-line method over its actual life.

Management has provided you with the following comparative manufacturing cost data.

	Present Equipment			New Equipment
Annual capacity (units)		426,000			426,000
Annual costs:
Labor	$	62,500		$	51,000
Depreciation		36,000			40,000
Other (all cash)		74,000			46,000
Total annual costs	$	114,000		$	85,000

The existing equipment is expected to have a salvage value equal to its removal costs at the end of 10 years. The new equipment is expected to have a salvage value of $86,000 at the end of 10 years, which will be taxable, and no removal costs. No changes in working capital are required with the purchase of the new equipment. The sales force does not expect any changes in the volume of sales over the next 10 years. The company’s cost of capital is 16 percent, and its tax rate is 25 percent. Use Exhibit A.8.

Required:

a. Calculate the removal costs of the existing equipment net of tax effects.

b. Compute the depreciation tax shield. (Round PV factors to 3 decimal places.)

c. Compute the forgone tax benefits of the old equipment.

d. Calculate the cash inflow, net of taxes, from the sale of the new equipment in year 10.

e. Calculate the tax benefit arising from the loss on the old equipment.

f. Compute the annual differential cash flows arising from the investment in years 1 through 10.

g. Compute the net present value of the project.

Answer 1

a. Calculate the removal costs of the existing equipment net of tax effects.
Particulars	Amount Rs.
Cost to Remove old equipment	$                     7,600
Tax saving there on@ 25%	-$                     1,900
Net	$                     5,700
b. Compute the depreciation tax shield. (Round PV factors to 3 decimal places.)
Year	PV Factor @ 16%	New Equipment (Given in Que.)	Present Equipment (SLM Basis)	Tax on dep for New Equipment	Tax on dep for Present Equipment	Tax shield on dep for New Equipment at NPV	Tax shield on dep for Present Equipment at NPV
1	$                     0.862	$             66,000	$    40,000	$     16,500	$           10,000	$                    14,223	$                           8,620
2	$                     0.743	$             96,000	$    40,000	$     24,000	$           10,000	$                    17,832	$                           7,430
3	$                     0.641	$             56,000	$    40,000	$     14,000	$           10,000	$                      8,974	$                           6,410
4	$                     0.552	$             56,000	$    40,000	$     14,000	$           10,000	$                      7,728	$                           5,520
5	$                     0.476	$             56,000	$    40,000	$     14,000	$           10,000	$                      6,664	$                           4,760
6	$                     0.410		$    40,000	$              -	$           10,000	$                             -	$                           4,100
7	$                     0.354		$    40,000	$              -	$           10,000	$                             -	$                           3,540
8	$                     0.305		$    40,000	$              -	$           10,000	$                             -	$                           3,050
9	$                     0.263		$    40,000	$              -	$           10,000	$                             -	$                           2,630
10	$                     0.227		$    40,000	$              -	$           10,000	$                             -	$                           2,270
	$                             5		Total			$                    55,421	$                         48,330
c. Compute the forgone tax benefits of the old equipment.
Particulars	Amount Rs
Labor	$                   62,500
Dep	$                   36,000
Other	$                   74,000
Total Annual Cost	$                1,14,000
	$                2,86,500
Tax there on @25%	$                   71,625
NPV for tax benefit forgone	$                3,46,164
d. Calculate the cash inflow, net of taxes, from the sale of the new equipment in year 10.
Particulars	Amount
Salvage Value	$                   86,000
Tax	$                   21,500
Net Inflow	$                   64,500
NPV at 10th Year	$                     0.227
Cash Inflow	$                   14,642
e. Calculate the tax benefit arising from the loss on the old equipment.
The existing equipment is expected to have a salvage value equal to its removal costs at the end of 10 years
Particulars	Amount
Cost will be	$                4,26,000
Depreciation	-$               3,60,000
Book vlaue	$                   66,000
Sale Value	-$                     7,600
Loss	$                   58,400
Tax benefit@25%	$                   14,600
f. Compute the annual differential cash flows arising from the investment in years 1 through 10.
Particulars	Present equipment	New Equipment
Labour	$                   62,500	$             51,000
Other Cash costs	$                   74,000	$             46,000
Total	$                1,36,500	$             97,000
Differential Cash outflows for all 10 years	$                   39,500
NPV	190903.5
g. Compute the net present value of the project.
Year 1
Investment outflow	$                2,65,000
Complusory Removal cost net off tax benefit	$                     5,700
Less Tax benefit due to dep	$                   55,421
Less NPV of savings in Costs	$                1,90,904
NPV of the project	$                   24,376