John?s Butter and Egg Business is such that he pays an effective tax rate of 40%

Question

John?s Butter and Egg Business is such that he pays an effective tax rate of 40%. John is considering the purchase of a new Turbo Churn for $40,000. This churn is a special handling device for food manufacture and has an estimated life of 4 years and a salvage value of $5,000. The new churn is expected to generate an addition gross income of $15,000 for each of the 4 years of use. If John works with an after- tax MARR of 14%, and use DDB depreciation, help him to decide if he should buy the churn with federal tax consideration. The DDB depreciation schedule. Find before-tax cash flows (BTCF) and after-tax cash flows (ATCF). Should he buy the churn and why?

Explanation / Answer

BTCF = Gross income+salvage value-depreciation

ATCF = (1-40%)*BTCF

Calculation of PV of ATCF using MIRR of 14%

Sum of all PVs = 10,831.61

Sum of book value of churn (as given in the question) = 40,000+20,000+10,000+5,000+5,000 = 80,000

So rate of return = profit after tax/book value of investment

= 1/5(10831.61)/(1/5*80,000) = 13.54%

As, the computed rate of return (13.54%) is less than MIRR (14%), the churn should not be bought.

Year Depreciation Gross income Salvage value BTCF Tax rate ATCF 0 0 0 0 0.40 0 1 20,000 15,000 -5,000 0.40 -3,000 2 10,000 15,000 5,000 0.40 3,000 3 5,000 15,000 10,000 0.40 6,000 4 0 15,000 5,000 20,000 0.40 12,000

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