Production equipment at a cost of $500,000 has been purchased by a contract manu
ID: 2796696 • Letter: P
Question
Production equipment at a cost of $500,000 has been purchased by a contract manufacturing company to meet the specific needs of customer that had awarded a 4-year contract with the possibility of extending the contract for another 4 years. The company plans to use the 7-year property MACRS depreciation method for this equipment. The income tax rate for the company is 39%, and it expects to have an after-tax rate of return of 12% for all its investments.
The equipment generated an annual income of $100,000 for the first four years. The customer decided not to renew the contract after 4 years. Consequently, the company decided to sell the equipment for $180,000 at the end of 4 years. Determine if the company correctly pursued this investment.yes or no is what the answers choices are
Explanation / Answer
Cost of Equipment is $500,000
Rate of return = 12%
Depreciation is through MACRS method- for 7 years. Referring MACRS table for7 years, for the first 4 years the depreciation %age is as follows:
7 Year MACRs
Depreciation
Year 1
14.29%
Year 2
24.49%
Year 3
17.49%
Year 4
12.49%
We refer to the first 4 years only as the company sells the equipment after the 4th year.
Now, given annual income of $100,000 per annum, we need to calculate the Cash Flow.
It is calculated as follows:
Year 0
Year 1
Year 2
Year 3
Year 4
Annual Income
0
$100,000
$100,000
$100,000
$280,000
Depreciation
0
($71,450)
($122,450)
($87,450)
($62,450)
EBT
($500,000)
$28,550
($22,450)
$12,550
$217,550
Tax
0
$11,134.50
$0.00
$4,894.50
$84,844.50
Net Income
($500,000.00)
$17,415.50
($22,450.00)
$7,655.50
$132,705.50
Cash Flow
($500,000.00)
$88,865.50
$100,000.00
$95,105.50
$195,155.50
* Depreciation for Year 1 = $500,000 x 14.29% = $71,450, and similarly for the rest of the years.
Note that the depreciation (despite being an expense) does not result in any cash flowing out of the organization. Hence, we add back the Depreciation to the Net Income to get the Cash Flow for each year.
Simply put,
Cash Flow = Net Income + Depreciation
Now, we have to find the Net Present Value of the Cash Flows discounted at 12%.
I have used Excel function NPV, to get the
NPV = PV of future Cash Flows - Initial Investment
NPV = $350,782.65 - $500,000 = -$149,217.35
AS NPV is negative, the investment pursued by the company is not correct.
7 Year MACRs
Depreciation
Year 1
14.29%
Year 2
24.49%
Year 3
17.49%
Year 4
12.49%
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