Question

Big-Pear Corp. is considering replacing its existing equipment that is used to produce smart cell phones. This existing equipment was purchase 3 years ago at a base price of $40,000. Installation costs at the time for the machine were $8,000. The existing equipment is considered a 5-year class for MACRS. The existing equipment can be sold today for $40,000 and for $30,000 in 3 years. The new equipment has a purchase price of $140,000 and is also considered a 5-year class for MACRS. Installation costs for the new equipment are $7,000. The estimated salvage value of the new equipment is $80,000. This new equipment is more efficient than the existing one and thus savings before taxes using the new equipment are $18,000 a year. Due to these savings, inventories will see a one time reduction of $2,000 at the time of replacement. The company's marginal tax rate is 20% and the cost of capital is 12%. For this project, what is the incremental cash flow in year 2?

MACRS Fixed Annual Expense Percentages by Recovery Class
Year	3-Year	5-Year	7-Year	10-Year	15-Year
1	33.33%	20.00%	14.29%	10.00%	5.00%
2	44.45%	32.00%	24.49%	18.00%	9.50%
3	14.81%	19.20%	17.49%	14.40%	8.55%
4	7.41%	11.52%	12.49%	11.52%	7.70%
5		11.52%	8.93%	9.22%	6.93%
6		5.76%	8.93%	7.37%	6.23%
7			8.93%	6.55%	5.90%
8			4.45%	6.55%	5.90%
9				6.56%	5.91%
10				6.55%	5.90%
11				3.28%	5.91%
12					5.90%
13					5.91%
14					5.90%
15					5.91%
16					2.95%

For your answer, round to the nearest dollar, do not enter the $ sign, use commas to separate thousands, use a negative sign in front of first number is the cash flow is negative (do not use parenthesis to indicate negative cash flows). For example, if your answer is $3,005.87 then enter 3,006; if your answer is -$1,200.25 then enter-1,200

For this project, the incremental cash flow in year 2 is:

Answer 1

Answer :

Calculation of Incremental Cash Flows for year 2:

Incremental Cash Flow = Before tax Savings * (1 - tax rate) + Tax shield on Incremental Depreciation

Tax shield on Incremental Depreciation = (Depreciation on new machine - Depreciation on Old machine) * Tax rate

Depreciation on New Machine = (Base Price + Installation) * Depreciation rate for 2nd year

= (140,000 + 7000) * 32%

= 47040

Depreciation on Existing Machine = (Base Price + Installation) * Depreciation rate for 5th year

= (40000 + 8000) * 11.52%

= 5529.6

Note : For existing machine rate of year 5 will be taken as it was purchased three years ago and we are calculating incremental cash flows for year 2

Tax shield on Incremental Depreciation = (47040 - 5529.6) * 20%

= 8302.08

Incremental Cash Flow = 18000 * (1 - 0.20) + 8302.08

= 22702.08 or 22,702

Answer 2

Answer :

Calculation of Incremental Cash Flows for year 2:

Incremental Cash Flow = Before tax Savings * (1 - tax rate) + Tax shield on Incremental Depreciation

Tax shield on Incremental Depreciation = (Depreciation on new machine - Depreciation on Old machine) * Tax rate

Depreciation on New Machine = (Base Price + Installation) * Depreciation rate for 2nd year

= (140,000 + 7000) * 32%

= 47040

Depreciation on Existing Machine = (Base Price + Installation) * Depreciation rate for 5th year

= (40000 + 8000) * 11.52%

= 5529.6

Note : For existing machine rate of year 5 will be taken as it was purchased three years ago and we are calculating incremental cash flows for year 2

Tax shield on Incremental Depreciation = (47040 - 5529.6) * 20%

= 8302.08

Incremental Cash Flow = 18000 * (1 - 0.20) + 8302.08

= 22702.08 or 22,702