Your company is considering the purchase of a new machine. The original cost of the old machine was $25,000; it is now five 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 six 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 five-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

The calculation for year 1 operating cash flow is:

Year 1 operating cash flow = (before-tax cash savings + depreciation tax shield) x (1 - tax rate)

Before-tax cash savings = $3,500
Depreciation tax shield = MACRS depreciation rate x (cost of new machine - estimated salvage value) x tax rate

The MACRS depreciation rate for 5-year property is 0.2, so the depreciation tax shield is:

0.2 x ($20,000 - $0) x 0.4 = $1,600

Therefore, the year 1 operating cash flow is:

($3,500 + $1,600) x (1 - 0.4) = $2,700

Option C is the best choice as it gives a positive operating cash flow for the first year.

Your Company Is Considering the Purchase of a New Machine