Valeria Products is considering the purchase of a new machine costing $800,000. The machine is expected to reduce annual operating costs by $120,000 and will be depreciated using the straight-line method (with no half-year convention) over ten years with no salvage value at the end of its useful life. Assuming a 30 percent income tax rate, the machine's payback period is:

Question

Quizplus · Accepted Answer

The payback period is calculated by dividing the initial investment by the annual cash inflow. The annual cash inflow is the reduction in operating costs adjusted for taxes. Since depreciation is $80,000 ($800,000/10 years) and the tax saving from depreciation is $24,000 ($80,000 * 30%), the net annual cost saving is $120,000 - $24,000 = $96,000. Therefore, the payback period is $800,000 / $96,000 = 8.33 years. However, the tax saving should not be subtracted from the cost saving. The correct annual cash inflow is the reduction in operating costs before taxes because depreciation tax shield is not a cash flow. So, the annual cash inflow is $120,000, and the payback period is $800,000 / $120,000 = 6.67 years. My initial explanation contained an error in the calculation of the tax effect on the annual cash inflow. The correct approach does not subtract the tax saving from the operating cost reduction for calculating the payback period.

Valeria Products Is Considering the Purchase of a New Machine