Dexter Smith & Co. is replacing a machine simply because it has worn out. The new machine will not affect either sales or operating costs and will not have any salvage value at the end of its five-year life. The firm has a tax rate of 22 percent, uses straight-line depreciation over an asset's life, ignores bonus depreciation options, and has a positive net income. Given this, which one of the following statements is correct?
A) As a project, the new machine has a net present value equal to minus one times the machine's purchase price.
B) The new machine will have a zero rate of return.
C) The new machine will generate positive operating cash flows.
D) The new machine will create a cash outflow when the firm disposes of the machine at the end of its life.
E) The new machine creates erosion effects.

Question

Quizplus · Accepted Answer

Since the new machine does not affect sales or operating costs, it will not have any impact on revenues or expenses. However, it will generate positive operating cash flows due to tax savings resulting from depreciation expense. Straight-line depreciation is used over the five-year life of the machine, which means an equal amount of depreciation expense will be recognized each year. Depreciation is a non-cash expense that reduces taxable income, thus reducing the firm's tax liability. The tax savings result in positive operating cash flows, which means the answer is C. The other answer choices are incorrect. A is incorrect because the net present value of the new machine will depend on the purchase price and cash flows, which are not given in the question. B is incorrect because the zero rate of return implies that the project's cash inflows equal its outflows, which is not the case in this question. D is incorrect because the question states that the new machine will not have any salvage value at the end of its life, so there will not be any cash inflow or outflow due to its disposal. E is incorrect because there is no indication that the new machine will have any negative impact on existing operations.