A firm is concerned about the condition of some of its plant machinery. Bill Jam
ID: 2463040 • Letter: A
Question
A firm is concerned about the condition of some of its plant machinery. Bill James, a newly hired engineer, reviewed the situation and identified five feasible, mutually exclusive alternatives. Alternative A: Spend $44,000 now repairing various items. The $44,000 can be charged as a current operating expense (rather than capitalized) and deducted from other taxable income immediately. These repairs will keep the plant functioning for 7 years with current operating costs. Alternative B: Spend $49,000 to buy general-purpose equipment. Depreciation would be straight line over the equipment's 7-year useful life. The equipment has no salvage value. The new equipment will reduce annual operating costs by $6000. Alternative C: Spend $56,000 to buy new specialized equipment. This equipment would be depreciated by sum-of-years' -digits depreciation over its 7-year useful life. This equipment would reduce annual operating costs by $12,000. It will have no salvage value. Alternative D: This alternative is the same as Alternative B, except it reduces annual operating costs by $7000. Alternative E: This is the "do nothing" alternative, with annual operating costs $8000 above the present level. This profitable firm pays 40% corporate income taxes and uses a 10% after-tax rate of return. Which alternative should the firm adopt?Explanation / Answer
Alternative (A)
Alternative (B)
Alternative (C)
Alternative (D)
Alternative (E)
Initial Cash Outflow (A)
$ 44,000.00
$ 49,000.00
$ 56,000.00
$ 49,000.00
$ -
Dep
$ -
$ 7,000.00
$ 8,000.00
$ 7,000.00
$ -
PV of Tax Saving on Dep (B)
$ -
$ 13,631.57
$ 15,578.94
$ 13,631.57
$ -
Reduction in Annual operating cost
$ -
$ 6,000.00
$ 12,000.00
$ 7,000.00
$ (8,000.00)
Extra Tax burden due to reduction in op. cost
$ 17,600.00
$ 2,400.00
$ 4,800.00
$ 2,800.00
$ (3,200.00)
Net Reduction
$ 26,400.00
$ 3,600.00
$ 7,200.00
$ 4,200.00
$ (4,800.00)
PV of Net Reduction
$ 26,400.00
$ 17,526.31
$ 35,052.62
$ 20,447.36
$ (23,368.41)
Net Cash Outflow (A) - (B) - ©
$ 17,600.00
$ 17,842.12
$ 5,368.44
$ 14,921.07
$ 23,368.41
Alternative (A)
Alternative (B)
Alternative (C)
Alternative (D)
Alternative (E)
Initial Cash Outflow (A)
$ 44,000.00
$ 49,000.00
$ 56,000.00
$ 49,000.00
$ -
Dep
$ -
$ 7,000.00
$ 8,000.00
$ 7,000.00
$ -
PV of Tax Saving on Dep (B)
$ -
$ 13,631.57
$ 15,578.94
$ 13,631.57
$ -
Reduction in Annual operating cost
$ -
$ 6,000.00
$ 12,000.00
$ 7,000.00
$ (8,000.00)
Extra Tax burden due to reduction in op. cost
$ 17,600.00
$ 2,400.00
$ 4,800.00
$ 2,800.00
$ (3,200.00)
Net Reduction
$ 26,400.00
$ 3,600.00
$ 7,200.00
$ 4,200.00
$ (4,800.00)
PV of Net Reduction
$ 26,400.00
$ 17,526.31
$ 35,052.62
$ 20,447.36
$ (23,368.41)
Net Cash Outflow (A) - (B) - ©
$ 17,600.00
$ 17,842.12
$ 5,368.44
$ 14,921.07
$ 23,368.41
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