Question

Operating cash inflows A partnership is considering renewing its equipment to meet increased demand for its product. The cost of equipment modifications is $1.9 million plus $100,000 in installation costs. The firm will depreciate the equipment modifications under MACRS, using a 5-year recovery period. (See Table 4.2 for the applicable depreciation percentages.) Additional sales revenue from the renewal should amount to $1,200,000 per year, and additional operating expenses and other costs (excluding depreciation and interest) will amount to 40% of the additional sales. The firm is subject to a tax rate of 40%. (Note: Answer the following questions for each of the next 6 years.)

1. What incremental earnings before interest, taxes, depreciation, and amortization will result from the renewal?

2. What incremental net operating profits after taxes will result from the renewal?

3. What operating cash flows will result from the renewal?

Table 4.2

Rounded Depreciation Percentages by Recovery Year Using MACRS for First Four Property Classes

	Percentage by recovery yeara
Recovery year	3 years	5 years	7 years	10 years
1	33%	20%	14%	10%
2	45	32	25	18
3	15	19	18	14
4	7	12	12	12
5		12	9	9
6		5	9	8
7			9	7
8			4	6
9				6
10				6
11				4
Totals	100%	100%	100%	100%

Answer 1

Tax rate		40%
Calculation of annual depreciation
Depreciation		Year-1	Year-2	Year-3	Year-4	Year-5	Year-6	Total
Cost		$    2,000,000	$   2,000,000	$    2,000,000	$    2,000,000	$   2,000,000	$    2,000,000
Dep Rate		20.00%	32.00%	19.00%	12.00%	12.00%	5.00%
Depreciation		$       400,000	$      640,000	$       380,000	$       240,000	$      240,000	$       100,000	$2,000,000
Calculation of annual operating cash flow
		Year-1	Year-2	Year-3	Year-4	Year-5	Year-6
Sale		$    1,200,000	$   1,200,000	$    1,200,000	$    1,200,000	$   1,200,000	$    1,200,000
Less: Operating Cost		$       480,000	$      480,000	$       480,000	$       480,000	$      480,000	$       480,000
Incremental earning before depreciation, interest, and tax		$       720,000	$      720,000	$       720,000	$       720,000	$      720,000	$       720,000
Less: Depreciation		$       400,000	$      640,000	$       380,000	$       240,000	$      240,000	$       100,000
Incremental earning before tax		$       320,000	$        80,000	$       340,000	$       480,000	$      480,000	$       620,000
Tax@40%		$       128,000	$        32,000	$       136,000	$       192,000	$      192,000	$       248,000
Incremental earning after tax		$       192,000	$        48,000	$       204,000	$       288,000	$      288,000	$       372,000
Add Depreciation		$       400,000	$      640,000	$       380,000	$       240,000	$      240,000	$       100,000
Incremental operating cashflow after tax		$       592,000	$      688,000	$       584,000	$       528,000	$      528,000	$       472,000