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 $245,000. If it is purchased, Dungan will incur costs of $6,800 to remove the present equipment and revamp its facilities. This $6,800 is tax deductible at time 0.

Depreciation for tax purposes will be allowed as follows: year 1, $58,000; year 2, $88,000; and in each of years 3 through 5, $48,000 per year. The existing equipment has a book and tax value of $118,000 and a remaining useful life of 10 years. However, the existing equipment can be sold for only $58,000 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)		418,000			418,000
Annual costs:
Labor	$	52,500		$	43,000
Depreciation		28,000			32,000
Other (all cash)		66,000			38,000
Total annual costs	$	106,000		$	77,000

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 $78,000 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) Cost of Removal for existing equipement:
Loss on sale of Equipment= $118000-$58000=$60,000
Cost of Removal of existing equipement= $ 6,800
Tax shield on above = ($60000+$6800) x 25% =$16,700
Cost of Removal for existing equipement net of Taxes:$60,000+$6,800-$16,700 = $50,100
b) Depreciation Tax Shield
Depreciation for Tax Purpose is given as below:
Year 1	$                     58,000
Year 2	$                     88,000
Year 3	$                     48,000
Year 4	$                     48,000
Year 5	$                     48,000
Total	$                 2,90,000
Depreciation Tax Shield:	$2,90,000 x 25% =	72,500
c) Forgone Tax benefits of the old equipment:
The existing equipment is being depreciated for book and tax purposes using the straight-line method over its actual life.
Depreciation p.a. = Tax value (-) Salvage Value / useful life
Depreciation p.a. =$ 118,000 (-) $ 6800 / 10
Depreciation p.a. = $ 11,120
Forgone Tax benefits = $ 11, 120 x 10 x 25% =	$27,800
d) cash inflow, net of taxes, from the sale of the new equipment in year 10
The new equipment is expected to have a salvage value of $78,000 at the end of 10 years, which will be taxable, and no removal costs
Inflow from Selling = $ 78,000
Tax on the Inflow = $ 78,000 x 25% = $ 19,500
Net Cash Inflow = $ 58,500
e) Tax benefit arising from the loss on the old equipment.
Loss on sale of Equipment= $118000-$58000=$60,000
Cost of Removal of existing equipement= $ 6,800
Tax shield on above = ($60000+$6800) x 25% =$16,700