Your company is considering the replacement of an old delivery van with a new on

Question

Your company is considering the replacement of an old delivery van with a new one that is more efficient. The old van cost $40,000 when it was purchased 5 years ago. The old van is being depreciated using the simplified straight-line method over a useful life of 8 years. The old van could be sold today for $7,000. The new van has an invoice price of $80,000, and it will cost $6,000 to modify the van to carry the company's products. Cost savings from use of the new van are expected to be $28,000 per year for 5 years, at which time the van will be sold for its estimated salvage value of $18,000. The new van will be depreciated using the simplified straight-line method over its 5-year useful life. The company's tax rate is 35%. Working capital is expected to increase by $5,000 at the inception of the project, but this amount will be recaptured at the end of year five. What is the tax effect of selling the old machine?

A) a tax savings of $1,400

B) a savings of $2,450

C) a savings of $2,800

D) additional taxes paid of $2,450

Explanation / Answer

The correct answer is C) a savings of $ $ 2,800

Workings:

Book value of old van = Cost - Accumulated depreciation = 40,000 - ( 40,000 / 8 x 5) = $ 15,000

Expected sale proceeds of old van = $ 7,000

Therefore loss on sale of old van = $ 7,000 - $ 15,000 = $ 8,000

Tax effect (savings) of the loss = $ 8,000 x 35% = $ 2,800

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