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2. A highly specialized piece of equipment has a first cost of $50,000. If this

ID: 2570258 • Letter: 2

Question

2. A highly specialized piece of equipment has a first cost of $50,000. If this equipment is purchased, it will be used to produce income (through rental) of $20,000 per year for only four years. Estimated annual expenses for upkeep are $3,000 per year during each of the four years. The MACRS (GDS) recovery period for the equipment is seven years and the effective income tax rate is 40%. The firm’s after-tax MARR is 7% per year. a. Assume that the equipment is placed on standby status after four years of service such that the depreciation is taken over the full MACRS recovery period. Since the equipment is on standby status the BTCF will be zero after the fourth year of use. However, a DWO can still be taken on the equipment until it is fully depreciated. Use a PW analysis and determine if the equipment should be purchased. b. Assume that the equipment will be donated to a university after its fourth year of use. The depreciation deduction in year four will be reduced by 50% due to the half-year convention. The remaining book value will be considered as a negative taxable income in year four thus providing additional tax relief in year four. The Instructor suggests that you separate the computations for these two items in your tabulation. Use a PW analysis and determine if the equipment should be purchased.
2. A highly specialized piece of equipment has a first cost of $50,000. If this equipment is purchased, it will be used to produce income (through rental) of $20,000 per year for only four years. Estimated annual expenses for upkeep are $3,000 per year during each of the four years. The MACRS (GDS) recovery period for the equipment is seven years and the effective income tax rate is 40%. The firm’s after-tax MARR is 7% per year. a. Assume that the equipment is placed on standby status after four years of service such that the depreciation is taken over the full MACRS recovery period. Since the equipment is on standby status the BTCF will be zero after the fourth year of use. However, a DWO can still be taken on the equipment until it is fully depreciated. Use a PW analysis and determine if the equipment should be purchased. b. Assume that the equipment will be donated to a university after its fourth year of use. The depreciation deduction in year four will be reduced by 50% due to the half-year convention. The remaining book value will be considered as a negative taxable income in year four thus providing additional tax relief in year four. The Instructor suggests that you separate the computations for these two items in your tabulation. Use a PW analysis and determine if the equipment should be purchased.
a. Assume that the equipment is placed on standby status after four years of service such that the depreciation is taken over the full MACRS recovery period. Since the equipment is on standby status the BTCF will be zero after the fourth year of use. However, a DWO can still be taken on the equipment until it is fully depreciated. Use a PW analysis and determine if the equipment should be purchased. b. Assume that the equipment will be donated to a university after its fourth year of use. The depreciation deduction in year four will be reduced by 50% due to the half-year convention. The remaining book value will be considered as a negative taxable income in year four thus providing additional tax relief in year four. The Instructor suggests that you separate the computations for these two items in your tabulation. Use a PW analysis and determine if the equipment should be purchased.

Explanation / Answer

a. Calculation of Net Cash flows from Purchasing the equipment  

Particulars

Amount (In $)

(A)

Time(n)

Present Value Factor (1/ (1.07)n), i=7%

(B)

Present Value Amount (In $)

(A x B)

Cash Outflows:

Purchase of equipment

50,000

0

1

50,000

TOTAL CASH OUTFLOWS

50,000

Rental Income

17,000

1-4

3.387 (Cumulative Present Value factor)

57,579

Tax Savings on Depreciation:

Tax saved on Depreciation expense for 1st year

50,000 x 14.29%

1

0.9345

6,677

Tax saved on Depreciation expense for 2nd year

50,000 x 24.40%

2

0.8734

10,655.48

Tax saved on Depreciation expense for 3rd year

50,000 x 17.49%

3

0.8163

7,138.54

Tax saved on Depreciation expense for 4th year

50,000 x 12.49%

4

0.7629

4764.31

Tax saved on Depreciation expense for 5th year

50,000 x 8.93%

5

0.713

3,183.545

Tax saved on Depreciation expense for 6th year

50,000 x 8.92%

6

0.6663

2971.70

Tax saved on Depreciation expense for 7th year

50,000 x 8.93%

7

0.6227

2,780.355

Tax saved on Depreciation expense for 8th year

50,000 x 4.46%

8

0.582

1,297.86

TOTAL TAX SAVINGS

39,468.79 x 40% = 15,787.516

Total Cash Savings/ Inflows

=57,579 + 15787.52 = $73,366.52

Net Present Value

23,366.52

Since the Net Present Value of Cash flows is positive, the equipment should be purchased.

Particulars

Amount (In $)

(A)

Time(n)

Present Value Factor (1/ (1.07)n), i=7%

(B)

Present Value Amount (In $)

(A x B)

Cash Outflows:

Purchase of equipment

50,000

0

1

50,000

TOTAL CASH OUTFLOWS

50,000

Rental Income

17,000

1-4

3.387 (Cumulative Present Value factor)

57,579

Tax Savings on Depreciation:

Tax saved on Depreciation expense for 1st year

50,000 x 14.29%

1

0.9345

6,677

Tax saved on Depreciation expense for 2nd year

50,000 x 24.40%

2

0.8734

10,655.48

Tax saved on Depreciation expense for 3rd year

50,000 x 17.49%

3

0.8163

7,138.54

Tax saved on Depreciation expense for 4th year

50,000 x 12.49%

4

0.7629

4764.31

Tax saved on Depreciation expense for 5th year

50,000 x 8.93%

5

0.713

3,183.545

Tax saved on Depreciation expense for 6th year

50,000 x 8.92%

6

0.6663

2971.70

Tax saved on Depreciation expense for 7th year

50,000 x 8.93%

7

0.6227

2,780.355

Tax saved on Depreciation expense for 8th year

50,000 x 4.46%

8

0.582

1,297.86

TOTAL TAX SAVINGS

39,468.79 x 40% = 15,787.516

Total Cash Savings/ Inflows

=57,579 + 15787.52 = $73,366.52

Net Present Value

23,366.52