A division of Raytheon owns a 5-year-old turret lathe used to manufacture fabric

Question

A division of Raytheon owns a 5-year-old turret lathe used to manufacture fabricated metal products that was purchased for $96,000 and now has a financial reporting (non-tax) book value of $24,000. It has been depreciated for tax purposes as MACRS-GDS 7-year property. It has a current market value of $18,000. The expected decline in market value is $3,000 per year from this point forward to a minimum of $3,000. O&M costs are $8,000 per year. Additional capability is needed. If the old lathe is kept, that new capability will be contracted out for $13,000, assumed payable at the end of each year. A new turret lathe has the increased capability to fulfill all needs, replacing the existing turret lathe and requiring no outside contracting. It can be purchased for $65,000 and will have an expected life of 8 years. Its market value is expected to be $65,000(0.7t) at the end of year t. Annual O&M costs are expected to equal $10,000. If the after-tax MARR is 9 percent, the tax rate is 40 percent, and the planning horizon is 8 years, determine whether to keep and use a contractor or to sell and buy new.

Clearly show the cash flow profile for each alternative using the cash flow approach (insider's viewpoint approach) EOY Keep existing turret lathe and contract out Replace with new turret lathe 0) 4 7

Explanation / Answer

WORKING NOTES:

*1: Depreciation calculations: Assuming Depreciation continues to be calculated at the applicable MACRS-GDS 7:

Since depreciation has already been charged for 5 years, the applicable dep rates and amounts are:

*2: Salvage value net of tax calculations:

WORKING NOTES:

*1: Net of tax sale of old machine, assuming tax saving on loss is applicable:

*2: Cost saving on depreciation per annum: Since the method of depreciation is not given, SLM is used.

*3: Profit on sale of new machine:

Recommendation: Keep existing turret lathe and contract out

Calculation of EUAC:

Keep Existing and contract Out EOY O&M Expenses (net of 40% tax) Contract expenses (net of 40% tax) Cost saving on depreciation (=Dep amount *tax rate) *1 Sale of old machine (net of 40% tax on profits)*2 Total Cash Flows 0 0 1 (4,800) (7,800) 3,425 0 (9,175) 2 (4,800) (7,800) 3,429 0 (9,171) 3 (4,800) (7,800) 1,713 0 (10,887) 4 (4,800) (7,800) 0 0 (12,600) 5 (4,800) (7,800) 0 0 (12,600) 6 (4,800) (7,800) 0 0 (12,600) 7 (4,800) (7,800) 0 0 (12,600) 8 (4,800) (7,800) 0 2,833 (9,767)

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