Your company is considering the purchase of a new machine. The original cost of

Question

Your company is considering the purchase of a new machine. The original cost of the old machine was $75,000; it is now 5 years old, and it has a current market value of $20,000. The old machine is being depreciated over a 10-year life toward a zero estimated salvage value on a straight-line basis, resulting in a current book value of $37,500 and an annual depreciation expense of $7,500. The old machine can be used for 6 more years but has no market value after its depreciable life is over. Management is contemplating the purchase of a new machine whose cost is $60,000 and whose estimated salvage value is zero. Expected before-tax cash savings from the new machine are $10,000 a year over its full MACRS depreciable life. Depreciation is computed using MACRS over a 5-year life, and the cost of capital is 9 percent. Assume a 40 percent tax rate. What will the year 1 operating cash flow for this project be?

Explanation / Answer

Hi,

Please find the detailed answer as follows:

Net Incremental Variable Costs = -10000

Total Depreciation Expense = Depreciation on New Machine - Depreciation on Old Machine/Machine Foregone = 12000 (60000*20%) -7500 (75000/10) = 4500

EBIT = 10000 - (-4500) = 5500

Operating Cash Flow = EBIT - Taxes + Depreciation = 5500 - 5500*40% + 4500 = $7800

Option C ($7800) is the correct answer.

Thanks.

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