Production equipment at a cost of $500,000 has been purchased by a contract manu
ID: 2796732 • 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.
Explanation / Answer
Year Initial Outflow Annual Income Depn Depn PBT Tax PAT OCF FCF Disc. Fact. PV 0 -5,00,000 -5,00,000 1.00000 -5,00,000 1 100000 14.29% 71,450 28,550 11,135 17,416 88,866 88,866 0.89286 79,344 2 100000 24.49% 1,22,450 -22,450 -8,756 -13,695 1,08,756 1,08,756 0.79719 86,699 3 100000 17.49% 87,450 12,550 4,895 7,656 95,106 95,106 0.71178 67,694 4 1,89,282 100000 12.49% 62,450 37,550 14,645 22,906 85,356 2,74,638 0.63552 1,74,537 NPV -91,725 Since zero >NPV so company has not correctly persued this investment Tax saving due to Depn Cost of Assets 5,00,000 Less: Depn till 4th Year 3,43,800 Less: Salavage Value 1,89,282 Net Loss -33,082 Tax Saving -12,902 Total Inflow at the end of 4th year Residual Value 1,89,282 Add; Tax Saving 12,902 Total Inflow 2,02,184
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