ABC purchased a machine for $2,575,000. Required modifications will cost $375,000. ABC will need to invest $75,000 for additional inventory. The machine has an IRS approved useful life of 7 years; it is presumed to have no salvage value. It will only be operated for 3 years, after-which it will be sold for $600,000. ABC plans to depreciate the machine by using the straight-line method. Assume that the firm's tax rate is 40%. What is the termination (non-operating) cash flow from the machine in year three?
A) $900,623
B) $1,109,286
C) $1,298,114
D) $879,247

Question

Quizplus · Accepted Answer

The termination cash flow in year three includes the after-tax salvage value and the tax effect due to the difference between the book value and the salvage value. The initial cost of the machine is $2,575,000, and the cost of modifications is $375,000, making the total cost $2,950,000. Using straight-line depreciation over 7 years, the annual depreciation is $2,950,000 / 7 = $421,429. After 3 years, the accumulated depreciation is $421,429 * 3 = $1,264,287. The book value at the end of year 3 is $2,950,000 - $1,264,287 = $1,685,713. The salvage value is $600,000, so the loss on sale is $1,685,713 - $600,000 = $1,085,713. The tax shield from this loss is $1,085,713 * 40% = $434,285. The after-tax salvage value is $600,000 + $434,285 = $1,034,285. Therefore, the termination cash flow is $1,034,285.

ABC Purchased a Machine for $2,575,000