Storage tanks to hold a highly corrosive chemical are currently made of material
ID: 2564167 • Letter: S
Question
Storage tanks to hold a highly corrosive chemical are currently made of material Z26. The capital investment in a tank is $32,000, and its useful life is eight years. Your company manufactures electronic components and uses the ADS for Asset Class 36.0 under MACRS to calculate depreciation deductions for these tanks. The net MV of the tanks at the end of their useful life is zero. When a tank is four years old, it must be relinec at a cost of $8,000. This cost is not depreciated and can be claimed as an expense during year four. Instead of purchasing the tanks, they can be leased. A contract for up to 20 years of storage tank service can be written with the Rent Al Company. I our firm's after tax MARR s 1 1% per year, what is the greatest annual amount that you can afford to pay for tank leasing without causing purchasing to be the more economical alternative? Your firm's effective income tax rate is 38%. Click the icon to view the partial listing of depreciable assets used in business. Click the icon to view the interest and annuity table for discrete compounding when the MARR is 11% per year. The greatest annual amount that you can afford to pay is $(Round to the nearest dollar)Explanation / Answer
Calculation of Net Cash flows from Purchasing the Tank
Particulars
Amount (In $)
(A)
Time(n)
Present Value Factor (1/ (1.11)n), i=11%
(B)
Present Value Amount (In $)
(A x B)
Cash Outflows:
Purchase of Tank
32,000
0
1
32,000
Expense in year 4 on Tank (Net of Tax savings)
8,000 x (1 - 0.38) = 4,960
4
0.6587
3,267.152
TOTAL CASH OUTFLOWS
35,267.152
Tax Savings on Depreciation:
Tax saved on Depreciation expense for half year of 1st year
2,666.66 x 38% = 1013.3308
1
0.9009
912.9097
Tax saved on Depreciation expense for 2nd to 6th year
5,333.33 x 38% = 2,026.6654
2-6
3.3296 (Cumulative PVF for 2-6 year)
6,747.9851
Tax Saved for half year of 7th year
2,666.66 x 38%= 1013.3308
7
0.4816
488.0201
TOTAL TAX SAVINGS
8,148.9149
NET Cash outflow from Purchasing the tank
27,118.2371
NOTE: Under ADS Depreciation is calculated on the basis of recovery period of that class of Asset. As per the table, 6 years is the recovery period under ADS. The very first year is considered for half year only and therefore, half depreciation is calculated for 1st and 7th year.
Depreciation for 1st Year & 7th Year = $32,000 / 6 years / 2 = $2,666.66
Depreciation for each next year till 6th year = $32,000 / 6 = $5333.33
For making the leasing a viable option we have to calculate annual amount, present value of which will be less than the net cash outflow from purchasing the Tank.
Cumulative Present Value factor at 11% MARR for 8 years = 5.1461
Therefore Net cash outflows from purchasing tank should be greater than the Present value of annual leasing amount net of Tax. Putting the same into formula we get
Net Cash out flows = Annual Leasing amount (1-Tax Rate) x Cumulative Present Value factor at MARR 11%
27,118.2371 = Annual Leasing Amount (1-0.38) x 5.1461
Annual Leasing Amount = 27,118.2371 / 5.1461(1-0.38) = 27,118.2371 / 3.19052 = $8,499.629
Particulars
Amount (In $)
(A)
Time(n)
Present Value Factor (1/ (1.11)n), i=11%
(B)
Present Value Amount (In $)
(A x B)
Cash Outflows:
Purchase of Tank
32,000
0
1
32,000
Expense in year 4 on Tank (Net of Tax savings)
8,000 x (1 - 0.38) = 4,960
4
0.6587
3,267.152
TOTAL CASH OUTFLOWS
35,267.152
Tax Savings on Depreciation:
Tax saved on Depreciation expense for half year of 1st year
2,666.66 x 38% = 1013.3308
1
0.9009
912.9097
Tax saved on Depreciation expense for 2nd to 6th year
5,333.33 x 38% = 2,026.6654
2-6
3.3296 (Cumulative PVF for 2-6 year)
6,747.9851
Tax Saved for half year of 7th year
2,666.66 x 38%= 1013.3308
7
0.4816
488.0201
TOTAL TAX SAVINGS
8,148.9149
NET Cash outflow from Purchasing the tank
27,118.2371
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