AFB, Inc. is considering replacing an old machine with a new one. Two months ago

Question

AFB, Inc. is considering replacing an old machine with a new one. Two months ago their chief engineer completed a training seminar on the new machine's operation and efficiency. The $3,000 cost for this training session has already been paid. If the new machine is purchased, it would require $7,000 in installation and modification costs to make it suitable for operation in the factory. The old machine originally cost $80,000 five years ago and is being depreciated by $10,000 per year. The new machine will cost $100,000 before installation and modification. It will be depreciated by $ 12,000 per year. The old machine can be sold today for $12,000. The marginal tax rate for the firm is 40%. Compute the relevant initial outlay in this capital budgeting decision.

Explanation / Answer

Answer:

Calculation of Initial outlay :

Cost of new machine = $100000

Add: Installation and modification charges = $7000

Less: sale value of old machine = $12000

Less: tax saving on loss on sale of old machine (See note below) $7200

Initial outlay = 100000 +7000 -12000-7200 = $87800

Note:

Calculation of Tax saving on loss on sale of old machine

Cost - Depreciation = 80000- (5*10000) = $30000

Sales value = $12000

Loss on sale = 30000-12000 = 18000

Tax saving on loss = 18000*40% = $7200

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