Your company is considering the purchase of a new machine. The original cost of the old machine was $25,000; it is now 5 years old, and it has a current market value of $10,000. The old machine is being depreciated over a 10-year life toward a zero estimated salvage value on a straight-line basis, resulting in a current book value of $12,500 and an annual depreciation expense of $2,500. The old machine can be used for 6 more years but has no market value after its depreciable life is over. Management is contemplating the purchase of a new machine whose cost is $20,000 and whose estimated salvage value is zero. Expected before-tax cash savings from the new machine are $3,500 a year over its full MACRS depreciable life. Depreciation is computed using MACRS over a 5-year life, and the cost of capital is 13 percent. Assume a 40 percent tax rate. What will the year 1 operating cash flow for this project be?

Question

Quizplus · Accepted Answer

Year 1 operating cash flow can be determined as follows:

After-tax cash savings from new machine = $3,500 x (1-0.4) = $2,100
Depreciation expense of new machine = $20,000 x 0.2 = $4,000
Tax shield from new machine depreciation = $4,000 x 0.4 = $1,600
Net cash flow from new machine = $2,100 + $1,600 = $3,700

Net cash flow from old machine = Salvage value - Tax on gain on sale
= ($10,000 - $12,500) x 0.4 = -$1,000

Total year 1 operating cash flow = $3,700 - $1,000 = $2,700. Therefore, option C is the best choice.

Your Company Is Considering the Purchase of a New Machine