Wilbur Corporation is considering replacing a machine. The replacement will cut

Question

Wilbur Corporation is considering replacing a machine. The replacement will cut operating expenses by $24,000 per year for each of the five years the new machine is expected to last. Although the old machine has a zero book value, it has a remaining useful life of five years. The depreciable value of the new machine is $72,000. Wilbur will depreciate the machine under MACRS using a 5-year recovery period and is subject to a 40% tax rate on ordinary income. Estimate the incremental operating cash flows attributable to the replacement. Be sure to consider the depreciation in year 6.

Explanation / Answer

It is a problem on capital budgeting. In these projects initially lump sum amount is invested.Thereafter project starts generating cash flows for more than one future years.

Here your company is considering replacement of a machine. It will reduce operating cost of $24,000. This cut will generate extra cash flow of $24,000 in each year. Depreciable value of this new machine is $72,000. You have to apply MACRS rate for charging depreciation.It is a modified accelerated cost recovery permitted under tax law. It believes that a fixed asset will provide best service at the initial stage of its life. So depreciation at accelerated rate will be charged on such assets. Here assets are grouped into several categories according to their expected life. Then a specified yearly rate as specified in the tax law is imposed on them. Here asset is of 5 years useful life category. So total depreciable amount will be recovered in six years. Rates are 20%, 32%, 19.20%, 11.52%, 11.52% and 5.76%. No cash will be paid for depreciation. But as per law depreciation is included in cost of goods sold. Hence it saves tax payable to federal authority. This savings in tax is another cash inflow. Thus incremental operating cash flow is the sum of operating expenses and tax saved on depreciation.

Thus incremental operating cash flow is:

Considering above table total 6 years cash inflow from the project will be

=$29,760+433,216+$29,530+427,318+$27,318+$1,659 = $148,801

                                      Statement showing incremental cash inflow of replacement project Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 1. Operating cost saved $24,000 $24,000 $24,000 $24,000 $24,000 2. Depreciation rate under MACRS 20% 32% 19.20% 11.52% 11.52% 5.76% 3. Depreciation [$72,000 x yearly rate] $14,400 $23,040 $13,824 $8,294 $8,294 $4,147 4. Tax saved [Depreciatio x 40%] $5,760 $9,216 $5,530 $3,318 $3,318 $1,659 5. Total incremental cash flow [1+4] $29,760 $33,216 $29,530 $27,318 $27,318 $1,659

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