Pavlovich Instruments, Inc., a maker of precision telescopes, expects to report

Question

Pavlovich Instruments, Inc., a maker of precision telescopes, expects to report pre-tax income of $430,000 this year. The company's financial manager is considering the timing of a purchase of new computerized lens grinders. The grinders will have an installed cost of $80,000 and a cost recovery period of 5 years. They will be depreciated using the MACRS schedule. The tax rate is 34%.

a.       If the firm purchases the grinders before year end, what depreciation expenses will it be able to claim this year? (Use Table 10.4 on page 308 of the Brooks text, and you can round the percentages to the nearest, e.g., 33.33% to 33%).<?xml:namespace prefix = o />

b.      If the firm reduces its reported income by the amount of the depreciation expense calculated in part a, what tax savings will result?   

c.       Assuming that Pavlovich does purchase the grinders this year and that they are its only depreciable asset, use the accounting definition given by the Equation:

FCF = OCF - Net fixed asset investment (NFAI) - Net current asset investment (NCAI)

to find the firm's cash flow from operations for the year.

Where:                                 OCF = [EBIT x (1-T)] + Depreciation

                                NFAI = change in net fixed assets + Depreciation

                                NCAI = change in current assets - change in (accounts payable + accruals)

Explanation / Answer

a)Depreciation = 80,000/5 = $16,000 / year ; b)EBIT = 430,000 - 16,000 = $414,000 OCF = 414,000*(1-0.34) + 16,000 = $289,240 ; If It would not have been purchased then ; OCF = 430,000*(1-0.34) = $283,800 ; Tax Savings = 289,240 - 283,800 = $5440

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