You are analyzing the purchase of new equipment.Since you are not an expert on this type of equipment,you hire a consulting firm to make recommendations.The consultant charged you $1,500 and recommended the purchase of the latest model from ACME Corp.of America.The equipment costs $80,000,and it will cost another $10,000 to modify it for special use by your firm.The equipment will be depreciated on a straight-line basis over six years with no salvage value.You expect the equipment will be sold after three years for $28,000.Use of the equipment will require an increase in your company's net working capital of $4,000,but this $4,000 will be recovered at the end of year three.The use of the equipment will have no effect on revenues,but it is expected to save the firm $50,000 per year in before-tax operating costs.Your company's marginal tax rate is 35%.What is the terminal cash flow for this project?

Question

Quizplus · Accepted Answer

To calculate the terminal cash flow we need to find the after-tax salvage value, which is calculated as the salvage value minus the tax on the sale of the equipment.

Salvage value = $28,000 
Tax on the sale = ($28,000 - book value) x tax rate 
Book value after three years = ($80,000 + $10,000) x (3/6) = $45,000 
Tax on the sale = ($28,000 - $45,000) x 0.35 = -$5,950 (note that the negative sign indicates a tax credit)

After-tax salvage value = $28,000 - (-$5,950) = $33,950

Therefore, the terminal cash flow is the after-tax salvage value of $33,950.

You Are Analyzing the Purchase of New Equipment