#4. (18 marks) Old Stone Farm wants to purchase brand new farm machinery for $20
ID: 2793064 • Letter: #
Question
#4. (18 marks) Old Stone Farm wants to purchase brand new farm machinery for $200,000. Its physical life is 25 years. The company's interest rate is 10% and its marginal corporate tax rate is 40%. The return on this purchase is 16%. Round all yourfi action rates to 3 decimal points. If the government requires them to use declining balance depreciation method as follows: the write off has to take place at the rate of 30%, whenever a balance of less than $48,500 is left it can be written off fully in the subsequent year. What is the present value of tax savings per dollar of expenditure. ? What is the user cost of capital? Should Old Stone Farm make this purchase? If the government requires them to use declining expenditure balance fraction (a) (b) method of depreciation: 15 of the cost can be deducted the first year, and for 45 every subsequent year the numerator drops by 3 (e.g. the second year fraction is 12 etc.) until the equipment is fully depreciated. What is the value of now? 45 What is the user cost of capital? Should Old Stone Farm make this purchase?Explanation / Answer
Cost of capital = post tax interest rate for company in both cases = 10 x (1-0.4) = 6% (a) Year Opening balance Depreciation Closing balance DTS = Depreciation x Tax rate PV factors @ 6% PV of DTS Post tax return on purchase PV of post tax return on purchase Pv of DTS and return on purchase 1 200000 60000 140000 24000 0.943396 22641.51 19200 18113.21 40754.717 2 140000 42000 98000 16800 0.889996 14951.94 19200 17087.93 32039.872 3 98000 29400 68600 11760 0.839619 9873.923 19200 16120.69 25994.613 4 68600 20580 48020 8232 0.792094 6520.515 19200 15208.2 21728.713 5 48020 48020 0 19208 0.747258 14353.33 19200 14347.36 28700.692 68341.22 149218.61 Return on purchase is 16% i.e.= 200000 x 16%= 32000 Less : 40% tax 12800 Post tax return 19200 PV of DTS and Return on purchase is less then cost of machine therefore purchase is not viable. (b) Year Opening balance Depreciation (in fractions) Depreciation amunt Closing balance DTS = Depreciation x Tax rate PV factors @ 6% PV of DTS Post tax return on purchase PV of post tax return on purchase Pv of DTS and return on purchase 1 200000 15/45 66666.67 133333.3333 26666.67 0.943396 25157.23 19200 18113.208 43270.44 2 133333.3 12/45 53333.33 80000 21333.33 0.889996 18986.59 19200 17087.932 36074.522 3 80000 9/45 40000 40000 16000 0.839619 13433.91 19200 16120.69 29554.599 4 40000 6/45 26666.67 13333.33333 10666.67 0.792094 8448.999 19200 15208.198 23657.197 5 13333.33 3/45 13333.33 0 5333.333 0.747258 3985.377 19200 14347.357 18332.734 70012.11 150889.49 Return on purchase = 32000 Less : 40% tax 12800 Post tax return 19200 PV of DTS and Return on purchase is less then cost of machine therefore purchase is not viable. Please provide feedback… Thanks in Advance :-)
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