Truth Dance Company, Inc., a manufacturer of dance and exercise apparel, is cons

Question

Truth Dance Company, Inc., a manufacturer of dance and exercise apparel, is considering replacing an existing piece of equipment with a more sophisticated machine.  

Existing Machine

Cost = $100,000

Purchased 2 years ago

Depreciation using MACRS over 5-year recovery schedule

Current market value = $105,000

Five year usable life remaining

Proposed Machine

Cost = $150,000

Installaion = $20,000

Depreciation - the MACRS a 5-year recovery schedule will be used

Five year usable life expected

Earnings before Depreciation and Taxes

Existing Machine

Year

1   $160,000

2   $150,000

3   $140,000

4   $140,000

5   $140,000

Proposed Machine

1   $170,000

2   $170,000

3   $170,000

4   $170,000

5   $170,000

The firm pays 40% taxes on ordinary income and capital gains

Questions:

a. Calculate the book value of the existing asset being replaced.

b. Calculate the tax effect from the sale of the existing asset.

c. Calculate the initial investment required for the new asset.

d. Summarize the INCREMENTAL after-tax cash flow (relevant cash flows) for years t=0 through t=5. (You will need the total cash flows from each machine to answer this question).

Explanation / Answer

a. Book value = $61220 ($100000-$14290-$24490)

b. Tax effect = $105000- $61220 = $43780 (Gain)

Tax on capital gain = $17512

c. Initial investment = $150000+$20000 - $105000= $65000

d.

Cost of New Machine $1,70,000 Life 5 Required Rate 10% Marginal Tax 40% Years 0 1 2 3 4 5 Increased earnings ($82,512) $10,000 $20,000 $30,000 $30,000 $30,000 Dep. 34000 54400 32640 19584 0 EBIT ($24,000) ($34,400) ($2,640) $10,416 $30,000 Tax ($9,600) ($13,760) ($1,056) $4,166 $12,000 Net Profit ($14,400) ($20,640) ($1,584) $6,250 $18,000 Cash Flow $24,400 $40,640 $31,584 $23,750 $12,000 PV ($82,512) $21,403.51 $31,271.16 $21,318.30 $14,062.14 $6,232.42 NPV $11,776

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