Question

Check my work Rockyford Company must replace some machinery that has zero book value and a current market value of $1,400. One possibility is to invest in new machinery costing $36,000. This new machinery would produce estimated annual pretax cash operating savings of $14,400. Assume the new machine will have a useful life of 4 years and depreciation of $9,000 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 $2,800 investment of net working capital. (Assume that when the old machine was purchased, the incremental net working capital required at the time was $0.) 0.25 points eBook 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. References 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 $2,800 of net working capital required in the current year?

Answer 1

			Current market value of old machinery									$        1,400
			Cost of new machinery									$      36,000
			Annual pretax operating cash savings of new machinery									$      14,400
			Useful life of new machine in years									4
			Annual depreciation expense for new machine									$        9,000
			Investment in working capital for new machine									$        2,800
			Income tax rate									40%
			After-tax cost of capital									14%
	SOLUTION
	1)	PV of after-tax cash flow arising from disposal of the old machine							$1,400*(1-0.40)			$           840
	2)	PV of after-tax cash flows attributable to the cash savings							$14,400*(1-0.40)*2.91			$      25,142
	3)	PV of the tax shield effect of depreciation at the end of year 1							($36,000/4)*0.40*0.87719			$        3,158
	4)	C.    It should be treated as part of the initial investment when determining the net present value.