Question

Calculating initial investment Vastine Medical, Inc., is considering replacing its existing computer system, which was purchased 2 years ago at a cost of $330,000. The system can be sold today for $196,000. It is being depreciated using MACRS and a 5-year recovery period (see the table E) A new computer system will cost $495,000 to purchase and install. Replacement of the computer system would not involve any change in net working capital. Assume a 40% tax rate on ordinary income and capital gains. a. Calculate the book value of the existing computer system. b. Calculate the after-tax proceeds of its sale for $196,000 c. Calculate the initial investment associated with the replacement project. 1 Data Table (Click on the icon located on the top-right corner of the data table below in order to copy its contents into a spreadsheet.) Rounded Depreciation Percentages by Recovery Year Using MACRS for First Four Property Classes Percentage by recovery year* Recovery year 3 years 5 years 7 years 10 years 33% 20% 14% 10% 45% 32% 25% 18% 15% 19% 18% 14% 7% 12% 12% 9% 9% 5% 9% 9% 7% 129 NOTO000 129 6% 6% 6% 11 4% Totals 100% 100% 100% 100% *These percentages have been rounded to the nearest whole percent to simplify calculations while retaining realism. To calculate the actual depreciation for tax purposes, be sure to apply the actual unrounded percentages or directly apply double-declining balance (200%) depreciation using the half-year convention.

Answer 1

Below is the depreciation schedule for the existing machine using the non rounded rates of MACRS 5 year:

Year	Opening balance	Depreciation rate	Depreciation	Closing balance
1	$        3,30,000.00	20.00%	$     66,000.00	$      2,64,000.00
2	$        2,64,000.00	32.00%	$ 1,05,600.00	$      1,58,400.00
3	$        1,58,400.00	19.20%	$     63,360.00	$         95,040.00
4	$            95,040.00	11.52%	$     38,016.00	$         57,024.00
5	$            57,024.00	11.52%	$     38,016.00	$         19,008.00
6	$            19,008.00	5.76%	$     19,008.00	$                         -

• Opening balance = previous year's closing balance
• Closing balance = Opening balance- Depreciation
• Depreciation = rate x cost
  • Depreciation = rate x 330000
• Book value at the end of 2 years =  $1,58,400.00
• Sale price is 196000
  • Profit = Sale price - Book value
  • Profit = 196000- 1,58,400.00
  • Profit = $37600
  • Tax on profit = 40% x  $37600
  • Tax on profit = $15040
• After Tax proceeds = Sale - Tax on profit
  • After Tax proceeds = 196000- 15040
  • After Tax proceeds = $180960
• Initial investment of replacement = Cost of new system - After tax proceeds of old system
  • Initial investment of replacement = 495000 - $180960
  • Initial investment of replacement = $314040