A Lotta Bread Corp. is replacing an entire baking line that was purchased for $420,000 and currently has a book value of $60,000. The new more efficient line will cost $940,000 installed and can be depreciated as a 7-year MACRS asset. With the increased efficiency, Lotta expects annual revenues to increase by $425,000 and operating expenses to increase by $170,000. The older machine, which was being depreciated at the straight-line rate of $20,000/year, will be sold for $30,000. What are the net cash flows for year 2? Assume the firm's marginal tax rate is 40% and that the year 2 depreciation rate is 24.49%.
A) $26,996
B) $332,206
C) $237,082
D) $383,206

Question

Quizplus · Accepted Answer

To calculate the net cash flows for year 2, we need to calculate the following:

- Operating Cash Flows: This is the cash flows resulting from the increased revenues and expenses.
- Tax Shield from Depreciation: This is the tax savings resulting from the depreciation of the asset.
- Salvage Value: This is the cash inflow resulting from the sale of the old machine.
- Initial Investment: This is the cash outflow resulting from the purchase of the new machine.

Operating Cash Flows:
The increase in revenues is $425,000 and the increase in expenses is $170,000, therefore the operating cash flow is:

Operating Cash Flow = Increase in Revenues - Increase in Expenses
Operating Cash Flow = $425,000 - $170,000
Operating Cash Flow = $255,000

Tax Shield from Depreciation:
The new machine is a 7-year MACRS asset and the year 2 depreciation rate is 24.49%. Therefore, the depreciation expense for year 2 is:

Depreciation Expense = Cost of Asset x Depreciation Rate
Depreciation Expense = $940,000 x 0.2449
Depreciation Expense = $230,156

The tax shield from depreciation is:

Tax Shield from Depreciation = Depreciation Expense x Marginal Tax Rate
Tax Shield from Depreciation = $230,156 x 0.4
Tax Shield from Depreciation = $92,062.40

Salvage Value:
The salvage value is $30,000.

Initial Investment:
The initial investment is the cost of the new machine minus the salvage value of the old machine. Therefore:

Initial Investment = Cost of New Machine - Salvage Value of Old Machine
Initial Investment = $940,000 - $30,000
Initial Investment = $910,000

Net Cash Flows:
The net cash flows for year 2 is:

Net Cash Flows = Operating Cash Flow + Tax Shield from Depreciation + Salvage Value - Initial Investment
Net Cash Flows = $255,000 + $92,062.40 + $30,000 - $910,000
Net Cash Flows = $237,082.40

Therefore, the best choice is C, with a net cash flow of $237,082.