Walter Miller, manufacturing vice president of Atlantic Industries, has been anx
ID: 2475933 • Letter: W
Question
Walter Miller, manufacturing vice president of Atlantic Industries, has been anxious for some time to purchase a piece of high-pressure equipment for use in the company's coal liquefaction research project. The equipment would cost $720,000 and would have an eight-year useful life. It would have a salvage value equal to about 5% of its original cost. In addition to the cost of the equipment, the company would have to increase its working capital by $10,000 to handle the more rapid processing of material by the new equipment.
An analysis that Mr. Miller has just received from his staff indicates that the equipment will not provide the 16% after-tax return required by Atlantic Industries. In making this analysis, Mr. Miller's staff estimated that the equipment would save the company $200,000 per year in its research program as a result of speeding up several key processes. The only significant maintenance work required on the equipment would be the installation of new pressure seals in five years at a cost of $80,000. In doing the analysis, Mr. Miller had instructed his staff to depreciate the equipment by the MACRS optional straight-line method, since the company always uses straight-line depreciation for accounting purposes. The company's tax rate is 30%. The equipment is in the MACRS five-year property class.
Upon seeing the analysis done by Mr. Miller's staff, the company's controller has suggested that the analysis be redone using the MACRS tables rather than the optional straight-line method. Somewhat irritated by this suggestion, Mr. Miller replied, "You accountants and your fancy bookkeeping methods! What difference does it make what depreciation method we use - we have the same investment, the same cost savings, and the same total depreciation either way. That equipment just doesn't measure up to our rate or return requirements. How you make the bookkeeping entries for depreciation won't change the fact."
1. Compute the net present value of the equipment using the optional straight-line method for computing depreciation as instructed by Mr. Miller.
2. Compute the net present value of the equipment using the MACRS tables as suggested by the controller. Round all dollar amounts to the nearest whole dollar.
3. Explain to Mr. Miller how the depreciation method used can affect the rate of return generated by an investment project.
Explanation / Answer
1.
*Assumption-Pressure seal would be depreciable.
working capital would be freed at the end
Salvage value would be tax-free
Year 1 2 3 4 5 6 7 8 Revenue inflows - - - - - - - - Costs outflows(Variable+fixed excluding dep.) – - - - - - - - - Before-tax net cash flows 200,000 200,000 200,000 200,000 200,000 200,000 200,000 200,000 Depreciation – 85,500 85,500 85,500 85,500 85,500 112167 112167 112167 Income before taxes 114,500 114,500 114,500 114,500 114,500 87,833 87,833 87,833 Taxes @ 30% – 34,350 34,350 34,350 34,350 34,350 26,350 26,350 26,350 After-tax net income 80,150 80,150 80,150 80,150 80,150 61,483 61,483 61,483 Depreciation + 85,500 85,500 85,500 85,500 85,500 112,167 112,167 112,167 After-tax cash flows 165,650 165,650 165,650 165,650 165,650 173,650 173,650 173,650 After-tax salvage value + - - - - - - - 36000 After-tax total net cash flows 165,650 165,650 165,650 165,650 165,650 173,650 173,650 219,650 including working capital of 10,000 Discount rate @ 16% 0.862 0.743 0.641 0.552 0.476 0.410 0.354 0.305 PV 142,790 123,095 106,124 91,487 78,866 71,266 61,437 66,993 742,058 Total present value 742,058 Initial investment - 730,000 including working capital of 10,000 NPV 12,058Related Questions
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