A 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 MACRS depreciation method for this equipment as a 7-year property for tax purposes. 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 obtained the expected after-tax rate of return on this investment.

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Quizplus · Accepted Answer

$$\begin{array} { | l | l | l | l | l | l | } \hline \text { Year } & \begin{array} { l } \text { BT-CF, } \ \mathbf { 5 } \end{array} & \begin{array} { l } \text { MACRS } \ \text { Depreciation Char ges, } \mathbf { 5 } \end{array} & \begin{array} { l } \text { Taxable } \ \text { Income, } \end{array} & \begin{array} { l } \text { Incume Tax } \ 09 \% , 5 \end{array} & \text { AT-CF, s } \ \hline 0 & - 500,000 & & & & - 500,000 \ \hline 1 & 100,000 & 0.1429 ( 500,000 ) = 71,450 & 28,550 & 11,251.50 & 88,748.50 \ \hline 2 & 100,000 & 0.2449 ( 500,000 ) = 122,450 & - 22,450 & - 8,755.50 & 108,755.50 \ \hline 3 & 100,000 & 0.1749 ( 500,000 ) = 87,450 & 12,550 & 4,894.50 & 95,105.50 \ \hline 4 & 100,000 & 0.1249 ( 500,000 ) = 62,450 & 37,550 & 14,644.50 & 85,355.50 \ \hline 4 & 180,000 & & 23,800 & 9,828.00 & 170,718 \ \hline \end{array}$$ Book value at the end of year 4 = $500,000 - (71,450+122,450+87,450+62,450) = $156,200 ^† Depreciation recapture = $180,000 ? $156,200 = $23,800 (Note that this is taxed as ordinary income) NPW of AT-CF @ 12% = 88,748.50 (P/F, 12%, 1) + 108,755.50 (P/F, 12%, 2) + 95,105.50 (P/F, 12%, 3) + 85,355.50 (P/F, 12%, 4) + 170,718 (P/F, 12%, 4) ? 500,000 =88,748.50 (0.8929) + 108,755.50 (0.7972) + 95,105.50 (0.7118) + (85,355.50) (0.6355) + 170,718 (0.6355) ? 500,000 = ?$103,626 The company did not get the 12% after-tax rate of return desired.

A Production Equipment at a Cost of $500,000 Has Been