Dear Tayba,
Let us do this problem in a detailed manner (for conceptual clarity);
Firstly let us analyse both machines cash flows results independently for Year1 (for a new machine) & in Year1 the old machine will be is in 6th year in its useful life period (as it is already used for 5 years) and then check the differential/incremental cash flow (if old machine replaced with the new one)
Details Old machine New Machine Differential/Incremental cash flows
Year Y1/1st year in 5 years of life Y1/6th year in 10 years of life
Revenue (assumed)* $ 500,000 $ 500,000 $ 0
Cash expenses (assumed)** ($ 300,000) ($ 270,000) $ 30,000
(Includes labour cost)
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Before-tax operating cash flows $200,000 $230,000 $ 30,000
Tax (40%) ($80,000) ($92,000) ($12,000)
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After-tax operating cash flows $ 120,000 $ 138,000 $ 18,000
Depreciation tax shield $ 2,000 $ 8,000 $ 6,000
OM - 5000*40% NM - 20,000*40%
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Net cash flows $122,000 $146,000 $ 24,000
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* assumed value and it is same for both machines, as the question silent about increase/decrease of revenue/sales
** assumed value and it is given that the before tax labour costs are reduced by 30,000 due to new machine, hence old machine labour costs are 30,000 more than the new machine labour cost, others cost remain the same.
Now, I think it is clear to you. In the exam, we should use differential/incremental cash flows.
Hence, the new machine contributing higher after-tax net cash inflows than the older one, the old machine should be replaced with the new machine. Remember when it comes to replacement of asset/project, always we take the decision, based on differential/incremental after-tax net cash flows.
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Areef Mohammed
Director/Manager
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Original Message:
Sent: 08-28-2020 04:13 AM
From: Tayba Al-Mehdar
Subject: Investment Decisions | Subunit 1: The Capital Budgeting Process
i am having trouble understanding the tax shield concept on replacement of equipments.
can anyone simplify it???
Study Unit 9: Investment Decisions | Subunit 1: The Capital Budgeting Process
| | Fact Pattern: Calvin, Inc., is considering the purchase of a new state-of-the-art machine to replace its hand-operated machine. Calvin's effective tax rate is 40%, and its cost of capital is 12%. Data regarding the existing and new machines are presented below. | Existing | New | | Machine | Machine | | | | Original cost | $50,000 | $90,000 | Installation costs | 0 | 4,000 | Freight and insurance | 0 | 6,000 | Expected end salvage value | 0 | 0 | Depreciation method | straight-line | straight-line | Expected useful life | 10 years | 5 years |
| | | | | Question: 17 | The existing machine has been in service for 5 years and could be sold currently for $25,000. Calvin expects to realize annual before-tax reductions in labor costs of $30,000 if the new machine is purchased and placed in service. If the new machine is purchased, the incremental cash flows for the first year would amount to | | | | | | | Answer (B) is correct.
The estimated incremental after-tax operating cash flows for each year of a capital project consist of two components, the after-tax cash inflows from operations and the difference in depreciation tax shields between the old and new equipment. The first of these for Calvin can be calculated as follows:Net annual labor cost savings | $30,000 | Less: Income tax expense ($30,000 × 40%) | (12,000) | | | After-tax cash inflow from operations | $18,000 | | |
The depreciation tax shield on the new equipment is derived as follows:Cost of new equipment ($90,000 + $4,000 + $6,000) | $100,000 | Divided by: Estimated useful life | ÷ 5 | | | Annual depreciation expense | $ 20,000 | Times: Tax rate | × 40% | | | Annual depreciation tax shield -- new equipment | $ 8,000 | | |
The depreciation tax shield on the old equipment is derived as follows:Cost of old equipment | $50,000 | Less: Accumulated depreciation [$50,000 × (5 ÷ 10 years)] | (25,000) | | | Current book value | $25,000 | Divided by: Remaining useful life | ÷ 5 | | | Annual depreciation expense | $ 5,000 | Times: Tax rate | × 40% | | | Annual depreciation tax shield -- old equipment | $ 2,000 | | |
The difference in the two depreciation tax shields is $6,000 ($8,000 – $2,000). Calvin's total incremental cash flow for the first year of this project is therefore estimated at $24,000 ($18,000 + $6,000). | | | | |
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Tayba Al-Mehdar
Analyst
Khobar
Saudi Arabia
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