Mahkota Engineering Sdn. Bhd., in the 20% income tax bracket, is considering the

Question

Mahkota Engineering Sdn. Bhd., in the 20% income tax bracket, is considering the purchase of a new piece of Machinery that will yield benefits of RM200,000 for year 1, RM300,000 for year 2, RM400,000 for year 3, RM400,000 for year 4, and RM400,000 for year 5. The Machinery is to be depreciated using the Modified Accelerated Cost Recovery System (MACRS) with three year recovery period (3-year property for Personal Property: Half Year Convention). The company believes the machinery can be sold at the end of five (5) years of use for 20% of the original purchase price, X. What is the maximum purchase cost, X the company can pay if it requires a 20% after tax rate of return? (23 Marks)

Explanation / Answer

EXPLANATIONS ARE GIVEN BELOW:

The maximum purchase cost should yield 0 NPV at the discount rate of 20%. The PV calculations are given below: Year Benefits After tax Benefits PVIF at 20% PV at 20% MACRS % MACRS %*20%*PVIF 1 200000 160000 0.83333 133333 20.00 3.33 2 300000 240000 0.69444 166667 32.00 4.44 3 400000 320000 0.57870 185185 19.20 2.22 4 400000 320000 0.48225 154321 11.52 1.11 5 400000 320000 0.40188 128601 11.52 0.93 768107 12.04 Equating the above for 0 NPV, we have 0 = -x+ 768107+12.04%*x+[0.2x-x*(20%-5.76%)*0.20)]*0.40188 where x is the maximum purchase cost. Solving for x 0 = -x+768107+0.1204x+0.0689x x = 768107/0.8107 = $947,462 (Answer) CHECK: Year Benefits After tax Benefits PVIF at 20% PV at 20% MACRS % MACRS DEPN DEPN TAX SHIELD PV OF DEPN TAX SHIELD 1 200000 160000 0.83333 133333 20.00 189492 37898 31582 2 300000 240000 0.69444 166667 32.00 303188 60638 42109 3 400000 320000 0.57870 185185 19.20 181913 36383 21055 4 400000 320000 0.48225 154321 11.52 109148 21830 10527 5 400000 320000 0.40188 128601 11.52 109148 21830 8773 768107 114046 PV OF AFTER TAX RESIDUAL VALUE: BOOK VALUE =947462*5.76% = $        54,574 SALVAGE VALUE = 947462*20% = $     189,492 GAIN $     134,919 20% TAX ON GAIN $        26,984 NET RESIDUAL VALUE $     162,509 PV of net residual value = 162509*0.40188 = $        65,309 NPV = 768107+114046+65309-947462= 0

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