Morage 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, Morage 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% under MACRS.
A)$26,996
B)$332,206
C)$237,082
D)$383,206

Question

Quizplus · Accepted Answer

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

1. Depreciation expense on the new machine for year 2:
Year 2 depreciation rate for 7-year MACRS property = 24.49%
Depreciation expense for year 2 = $940,000 x 24.49% = $230,756

2. Depreciation expense on the old machine for year 2:
Depreciation expense for year 2 = $20,000 (straight-line rate)

3. Gain/loss on sale of old machine:
Book value of old machine = $60,000 - ($20,000 x 2 years) = $20,000
Gain/loss on sale of old machine = $30,000 - $20,000 = $10,000 (taxable since it's a gain)

4. Incremental operating cash flows:
Incremental revenues = $425,000
Incremental expenses = $170,000
Incremental operating cash flows = $425,000 - $170,000 = $255,000

5. Tax savings due to depreciation:
Tax savings = (New depreciation expense - Old depreciation expense) x Tax rate
Tax savings = ($230,756 - $20,000) x 40% = $84,302.40

Net cash flows for year 2 = Incremental operating cash flows - Tax on gain + Tax savings + New depreciation expense - Old depreciation expense
Net cash flows for year 2 = $255,000 - ($10,000 x 40%) + $84,302.40 + $230,756 - $20,000
Net cash flows for year 2 = $237,082.40

Therefore, the best choice is C: $237,082.