Your firm can purchase a machine for $12,000 to replace a rented machine. The re

Question

Your firm can purchase a machine for $12,000 to replace a rented machine. The rented machine costs $4,000 per year. The machine that you are considering would have a useful life of eight years and a $5,000 MV at the end of its useful life. By how much could annual operating expenses increase and still provide a return of 12% per year after taxes? The firm is in the 40% income tax bracket, and revenues produced with either machine are identical. Assume that the straight line method is utilized to recover the investment in the machine over its useful life with a salvage value of $5,000.

Explanation / Answer

Note : there sale is calculated on required return basis

Particular Rented machine Investment Amount in $ Amount in $ Present Proposed Sale 12000 12000 less: operating expenses 5600 8725 Operating profit 6400 3275 Less: fixed expense             Rent 4000 0             Depriciation 0 875 Earning Before interest and tax 2400 2400 Less: interest 0 0 Earning Before tax 2400 2400 Less: Tax 960 960 Earning after tax 1440 1440 Working note : 1 Rate of return @12% $12000*.12 = 1440 Working note : 2 Depriciation Value - Scrap value/life Value of machine $12000 $12000-$5000/8 = $875 scrap value   $5000 life            8 year Working note : 3 Required return @12% = $1440 sale = $1440/.12 = $12000 Note : Required rate of return @12% of investment

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