A company is considering acquiring a machine for $352,000. The machine will auto

Question

A company is considering acquiring a machine for $352,000. The machine will automate a process currently performed manually. The introduction of the machine will allow the company to avoid paying annual salaries and benefits over the life of the project, during which salaries and benefits are not expected to grow. No other revenues or expenses will be affected except for those related to the production of another product (below). The machine will occupy floor space currently being used to make another product that contributes $44,000 per year to the company's before-tax cash flow. If it acquires the machine, it would have to discontinue making that product. The project is expected to last for six years. However, the machine must be depreciated by the straight-line method over an eight-year life to a zero salvage value for income tax purposes. At the end of the project, the company expects to be able to sell the machine for $38,500, net of disposal costs. This amount will fall to $16,500 by year eight. Assuming that the appropriate after-tax MARR is fourteen percent, what is the minimum amount of before-tax savings from salaries and benefits that the company needs in order to justify acquiring the machine? The relevant income tax rate is 40%.

Explanation / Answer

Solution:

Let the saving in salaries be $ x per year

Year 1 to 5 Year 6 Savings in Salaries x x Less: Loss of Contribution 44,000 44,000 Less: Incremental Depreciation ( $ 352,000 - 38,500 / 6) 52250 52250 Add: Salvage Value 38,500 Net Incremental Revenue x - 96,250 x - 57,750 Less: Tax ( 40 % ) 0.4x - 38,500 0.4x - 23,100 After Tax Revenue 0.6 x - 57,750 0.6x - 34,650 Add: Depreciation 52250 52250 Cash flows 0.6x + 5,500 0.6x + 17,600 Present value factor of $ 1 @ 14 % 3.433 0.4556 Present Values 2.0598x + 18,881.6 0.27336x + 8,018.56 Total Present Values 2.33316x + 26,900.16 In order to accept the project NPV = Present Vlaue of Cashflows - Initial Investment should be equal , therefore, $ 352,000 = 2.33316x +26,900.16 $ 352,000 = 2.33316x +26,900.16 x = 2.33316x +26,900.16 x = 139,338.85 Therefore, salaries must be $ 139,338.85

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