Question

Answer questions 1 through 4 regarding Rockyford Company

Rockyford Company must replace some machinery that has zero book value and a current market value of $2,600. One possibility is to invest in new machinery costing $48,000. This new machinery would produce estimated annual pretax cash operating savings of $19,200. Assume the new machine will have a useful life of 4 years and depreciation of $12,000 each year for book and tax purposes. It will have no salvage value at the end of 4 years. The investment in this new machinery would require an additional $3,800 investment of net working capital. (Assume that when the old machine was purchased, the incremental net working capital required at the time was $0.) If Rockyford accepts this investment proposal, the disposal of the old machinery and the investment in the new one will occur on December 31 of this year. The cash flows from the investment are expected to occur over a four-year period Rockyford is subject to a 40% income tax rate for all ordinary income and capital gains and has a 14% weighted average after-tax cost of capital. All operating and tax cash flows are assumed to occur at year-end. (For Parts 2 and 3, use the relevant table from Appendix C-Table 1 or Table 2.) Required: 1. Determine the after-tax cash flow arising from disposing of the old machinery. 2. Determine the present value of the after-tax cash flows for the next 4-years attributable to the cash operating savings. 3. Determine the present value of the tax shield effect of depreciation for year 1. 4. Which one of the following is the proper treatment for the additional $3,800 of net working capital required in the current year?

Answer 1

Requirement 1. Determine the after tax cash flow arising from disposing of the old machinery.

Particulars	Amount
Market Value of Current Machine	$ 2,600
Less ; Book value of current machine	0
Gain on disposal of old machinery	$ 2,600
Tax on capital Gain ( $2,600*40%)	$1,040
After tax cash flow from disposing old machinery	$ $1,560

Requirement 2. Determine the present value of the after tax cash flow for the next 4 years attributable to cash operating savings.

Particulars	Amount
Annual Pre tax cash operating savings	$ 19,200
Less; Taxes ($ 19,200 * 30 %)	$ 5,760
Annual Post tax cash operating savings	$ 13,440
PVAF (14% , 4)	2.9137
Present value of after tax cash flow (2.9137 * $ 11,480)	$ 33,449.28

Requirement 3; Determine the present value of the tax shield effect of depreciation for year 1.

Particulars	Amount
Depreciation	$ 12, 000
Tax Shield on depreciation ($12,000*30)	$ 3,600
Present Value In Flow (14%, 1 )	.8772
Present Value of tax shield effect of depreciation (.8772 * $3,600)	$ 3157.92

Requirement 4;

Additional Net Working Capital is required, it is a part of initial investment. When calculating the Net Present Value. The Net working capital is required as investment. That means current year and it is treated as a part of Investment.