Blazer, Inc., a manufacturer of children’s apparel, is considering replacing an

Question

Blazer, Inc., a manufacturer of children’s apparel, is considering replacing an existing piece of equipment with a more sophisticated machine. The following information is given. (Look up MACRS percentages at “irs.gov”) The firm pays 40 percent taxes on both ordinary income and capital gains.

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.)

Facts Existing Machine Cost 100,00 Purch ased 2 years ago Depreciation using MACRS over Depreciation the MACRS Proposed Machine Cost = 150,000 Installation 20,000 a 5-vear recover schedule Current market value- $105,000 Five vear usable life remainin 5-vear recovery schedule will be used Five vear usabl life expected Earnings before Depreciation and Taxes Proposed Machine Year 1 $160,000 Year $170,000 2 170,000 3 170,000 4170,000 5170,000 Existing Machine 2150,000 3 140,000 4140,000 5140,000

Explanation / Answer

a. Computation of Book value of the existing asset being replaced. Cost of machine(2 Years ago)          100,000 Depreciation Using Declining Balance Method (Half-Year Convention) Year. Dep. Percentage Amount 1 10.71%            10,710 2 19.13%            19,130 Book value of machine            70,160 b. Computation of Tax effect from the sale of the existing asset. Sales value of machine( at Current market value)          105,000 Book value of machine            70,160 Capital Gain            34,840 Tax on capital gain@40%            13,936 c. Computation of Initial investment required for the new asset Cost of New machine                             150,000 Installation Charges                                20,000 Total                             170,000 d. Computation of incremental after-tax cash flow Existing machine Proposed machine Year EBDT Depreciation Cash flow net of tax EBDT Depreciation Cash flow net of tax 1 160000 15030 139171.2 170000 25500 138720 2 150000 12250 132240 170000 43350 126650 3 140000 12250 122640 170000 30345 139655 4 140000 12250 122640 170000 28322 141678 5 140000 12250 122640 170000 28322 141678

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