The Quick Manufacturing Company, a large profitable corporation, is considering

Question

The Quick Manufacturing Company, a large profitable corporation, is considering the replacement of a production machine tool. A new machine would cost $3700, have a 4- year useful and depreciable life, and have no salvage value. For tax purposes , sum of years' digits depreciation would be used. The existing machine tool was purchased 4 years ago at a cost of $4000 and has been depreciated by straightline depreciation assuming an 8 year life and no salvage value. The tool could be sold now to a used equipment dealer for $1000 or be kept in service for another 4 years. It would then have no salvage value. The new machine tool would save about $900 per year in operating costs compared to the existing machine. Assume a 40% combined state and federal tax rate.

A Replacement Analysis based on Annual Equivalent of Cash Flow After Taxes MUST be conducted.
Assume i=10%% and there is a 4 years plan of study for both the challenger and defender in this case.

I have what the answers should be but I'd like to see how it's done correctly..

Explanation / Answer

Solution.

Replacement Analysis based on Annual Equivalent of Cash Flow After Taxes

Working Notes:

1. Calculation of present value of depreciation for New Machine

2. Calculation of present value of depreciation for Old Machine

Cumulative present value factor @10% for 4 years = 3.17

Annual Depreciation on old machine by SLM = 4000/8 =$500

Present value of depreciation for next 4 years = $500*3.17 = $1585

3. Calculation of tax saving on capital gain on sale of old machine

Written down value of old machine today = $4000 - ($500*4) = $2000

Current sale value = $1000

Loss on sale of machine = $2000-$1000= $1000

Tax saving on loss = $1000*40% = $400

4. Calculation of Present Value of operating Costs saved if new machine is used

Cumulative present value factor @10% for 4 years = 3.17

Annual Operating costs saved = $900

Present Value = $900*3.17 = $2853

5. Tax saving on additional depreciation if new machine is used

Present Value of Depreciation if new machine is used (W/N 1) = $3070.63

Present Value of Depreciation if old machine is used (W/N 2) = $1585

Present value of additional depreciation = $3070.63 - $1585 = 1485.63

Tax Rate = 40%

Present value of Tax Saving = $1485.63 * 40% = $594.25

Inflows / (Outflows) Amount ($) Purchase of New machine (3700) Sale of Old Machine 1000 Tax saving on loss on sale of old machine (W/N 3) 400 Present Value of operating Costs saved by new machine (W/N 4) 2853 Present value of Tax Saving on additional depreciation (W/N 5) 594.25 Additional Inflows if new machine is purchased $1147.25

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