Question

Tax Impact Capital Investment Projects typically have 4 major categories: 1. Initial Investment: Cash outflow to purchase a new machine and the working capital cash outflows (if any) at year o 2. Current disposal of old machine and the effects of gain/loss from sales old machine on tax paid or tax savings (in case of sold of old machine) at year 0. 3. Annual net cash flow from operations: difference between net cash flows under old machine and new machine and the difference of the cash flow on tax paid/savings. In addition, the difference in depreciation on tax paid/tax savings during the project period 4. Terminal Value of Investment :Salvage (Residual) Value of New Machine and recovery of working capital (if any) Example 1 JJ company wants to replace the old machine. Machine is used in molding the components. The old machine was acquired three year ago. Its remaining useful life is 5 years and salvage value is $10,000. Book value of old machine is

Answer 1

1. Calculation of Incremental Initial Investment

Tax on sale of old machine = (Sale price - Book Value)*Tax rate = (75000 - 70000)*30% = $1,500

Net Realizable Value of old machine, if sold today = 75000 - 1500 = $73,500

Incremental Initial Investment = Purchase price of old machine - Net Realizable Value of old machine = 150000 - 73500 = $76,500

2. Calculation of Incremental Subsequent Annual Cash Inflow

Depreciation using straight line = (Cost - Salvage Value)/Number of years of useful life

Depreciation on old machine = (70000 - 10000)/5 = $12,000 per year

Depreciation on new machine = (150000 - 40000)/5 = $22,000 per year

Incremental Depreciation = 22000 - 12000 = $10,000

Savings in cash operating cost = 20000 - 12000 = $8,000

Incremental Subsequent Annual Cash Inflow = (Savings in cash operating cost - Incremental Depreciation)*(1 - Tax rate) + Incremental Depreciation = (8000 - 10000)*(1 - 0.30) + 10000 = $8,600

3. Incremental Salvage Value

Incremental Salvage Value = Salvage value of new machine - Salvage value of old machine = 40000 - 10000 = $30,000

Decision:

NPV of buying new machine = Incremental Subsequent Annual Cash Inflow*PVIFA(8%,5) + Incremental Salvage Value*PVIF(8%,5) - Incremental Initial Investment = 8600*3.9927 + 30000*0.6806 - 76500 = -$21,744.78

Since the NPV of buying new machine is negative, we should not buy the new machine.