question archive Rockyford Company must replace some machinery that has zero book value and a current market value of $1,500
Rockyford Company must replace some machinery that has zero book value and a current market value of $1,500
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Rockyford Company must replace some machinery that has zero book value and a current market value of $1,500. One possibility is to invest in new machinery costing $38,000. This new machinery would produce estimated annual pretax cash operating savings of $15,200. Assume the new machine will have a useful life of 4 years and depreciation of $9,500 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 $2,900 investment of net working capital (Assume that when the old machine was purchased, the incremental net working capital required at the time was $0.) 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. Rockyford is subject to a 40% Income tax rate for all ordinary income and capital gains and has a 13% 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 Arrendix 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 $2,900 of net working capital required in the current year?
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1) Current Market value of old machinery = $1,600
Book Value of old machinery = $0
Tax rate = 40%
After-Tax cashflow from disposing the old machinery = Current Market value of old machinery * (1 - Tax rate)
After-Tax cashflow from disposing the old machinery = 1,600 * (1 - 40%) = 1,600 * 60%
Hence, After-Tax cashflow from disposing the old machinery = $ 960
2) Annual Pretax Cash Operating savings = $ 15,200
After-tax Cash Operating savings = Pre-tax cash operating savings * (1 - Tax rate) = 15,200 * (1 - 40%)
After-tax Cash Operating savings = 15,200 * 60% = $9,120
Life of machine or T = 4 years | Cost of capital or R = 13%
PV of After-tax cash operating savings over 4 years = After-tax Cash Operating savings * (1 - (1 + R)-T) / R
PV of After-tax cash operating savings over 4 years = 9,120 * (1 - (1 + 13%)-4) / 13% = 9,120 * 2.9745
Hence, PV of After-tax cash operating savings over 4 years = $ 27,127.18
3) Annual Depreciation = $9,500
Tax rate = 40%
Depreciation Tax shield in Year 1 = Depreciation * Tax rate = 9,500 * 40% = $3,800
Present Value of Depreciation Tax Shield of Year 1 = Depreciation Tax shield in Year 1 / (1 + R)
Present Value of Depreciation Tax Shield of Year 1 = 3,800 / (1 + 13%) = 3,800 / 1.13
Hence, Present Value of Tax shield effect of depreciation for Year 1 = $ 3,362.83
4) The $2,900 of Net working capital required in current year cannot ignore or treated as a sunk cost, as it is an incremental cashflow which affects the capital budgeting analysis. Moreover, it also cannot be combined with machinery cost and depreciated over 4 years or distributed among the years as cashflows.
The $2,900 Net working capital required should be treated as a part of Initial investment during the capital budgeting or NPV analysis of the new machinery.
