Question

A $500,000 piece of production equipment has been purchased by a contract manufacturing company to meet the specific needs of a customer. The customer awarded the manufacturing company a 4-year contract with the possibility of extending the contract for another 4 years. The company plans to use the MACRS depreciation method for this equipment as a 7-year property for tax purposes. The income tax rate for the company is 39%, and it expects to have an after -tax rate of return of 12% for all its investments.

The equipment generated an annual income of $100,000 for the first four years. The customer decided not to renew the contract after 4 years. Consequently, the company decided to sell the equipment for $180,000 at the end of 4 years.

Was this a good investment for the company? Explain your answer.  

Answer 1

Working notes:

(a) MACRS depreciation schedule as follows.

Year	Cost ($)	Depreciation Rate (%)	Depreciation ($)
1	5,00,000	14.29	71,450
2	5,00,000	24.49	1,22,450
3	5,00,000	17.49	87,450
4	5,00,000	12.49	62,450

(b) Taxable income (TI) = Annual income - Depreciation = $100,000 - Depreciation

(In year 4, TI = $100,000 - Depreciation + $180,000 market price = $280,000 - Depreciation)

(c) After-tax income = TI x (1 - Tax rate) = TI x (1 - 0.39) = TI x 0.61

(d) After-tax cash flow (ATCF) = After-tax income + Depreciation

(e) PW of ATCF is as follows. Note that PV Factor in year N = (1.12)^-N.

Year	TI ($)	Depreciation ($)	After-tax income ($)	ATCF ($)	PV factor @12%	Discounted ATCF ($)
0				-5,00,000	1.0000	-5,00,000
1	28,550	71,450	17,416	88,866	0.8929	79,344
2	-22,450	1,22,450	-13,695	1,08,756	0.7972	86,699
3	12,550	87,450	7,656	95,106	0.7118	67,694
4	2,17,550	62,450	1,32,706	1,95,156	0.6355	1,24,025
					PW ($) =	-1,42,238

Since PW of ATCF is negative, this is not a good investment.