Question

Universal Electronics is considering the purchase of manufacturing equipment with a 10-year midpoint in its asset depreciation range (ADR). Carefully refer to Table 12–11 to determine in what depreciation category the asset falls. (Hint: It is not 10 years.) The asset will cost $130,000, and it will produce earnings before depreciation and taxes of $36,000 per year for three years, and then $18,000 a year for seven more years. The firm has a tax rate of 25 percent. Assume the cost of capital is 10 percent. In doing your analysis, if you have years in which there is no depreciation, merely enter a zero for depreciation. Use Table 12–12. Use Appendix B for an approximate answer but calculate your final answer using the formula and financial calculator methods.

Answer 1

The manufacturing equipment has 10-year midpoint ADR, thus the depreciation would be written off based on 7-year MACRS

This is because this category has assets with useful life of 10 years or more and includes manufacturing equipment.

1.Computation of Net present value

Year	0	1	2	3	4	5	6	7	8	9	10
Earnings before depreciation and taxes		36,000	36,000	36,000	18,000	18,000	18,000	18,000	18,000	18,000	18,000
Less: Depreciation		18,590	31,850	22,750	16,250	11,570	11,570	11,570	5,850
Earnings before taxes		17,410	4,150	13,250	1,750	6,430	6,430	6,430	12,150	18,000	18,000
Less: Taxes @ 25%		4,352.50	1,037.50	3,312.50	437.50	1,607.50	1,607.50	1,607.50	3,037.50	4,500	4,500
Net income		13,057.50	3,112.50	9,937.50	1,312.50	4,822.50	4,822.50	4,822.50	9,112.50	13,500	13,500
Add: Depreciation		18,590	31,850	22,750	16,250	11,570	11,570	11,570	5,850
Cash flow		31,647.50	34,962.5	32,687.50	17,562.50	16,392.50	16,392.50	16,392.50	14,962.50	13,500	13,500
Purchase of equipment	-130,000
Net cash flow	-130,000	31,647.50	34,962.5	32,687.50	17,562.50	16,392.50	16,392.50	16,392.50	14,962.50	13,500	13,500
Discount factor @ 10% (1/(1.10^n))	1	0.90909	0.82644	0.75131	0.68301	0.62092	0.56447	0.51315	0.46650	0.42409	0.38554
Present value	-130,000	28,770.43	28,894.40	24,558.45	11,995.36	10,178.43	9,253.07	8,411.81	6,980.01	5,725.22	5,204.79
Net present value	9,971.97

Conclusion: Company should purchase the machine as NPV is positive.

workings:

Depreciation on asset
Year 1	(130,000*0.143)	18,590
Year 2	(130,000*0.245)	31,850
Year 3	(130,000*0.175)	22,750
Year 4	(130,000*0.125)	16,250
Year 5	(130,000*0.089)	11,570
Year 6	(130,000*0.089)	11,570
Year 7	(130,000*0.089)	11,570
Year 8	(130,000*0.045)	5,850