# CMA Study Group

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## Capital Budgeting : Salvage Value

• #### 1.  Capital Budgeting : Salvage Value

Posted 13 days ago
Alexander Manufacturing is planning to purchase a machine costing \$185,000 to replace fully depreciated production equipment. Alexander expects to receive \$2,200 through the sale of the old equipment, which was purchased six years ago for \$137,000. For the duration of the new machine's useful life, Alexander estimates needing to commit working capital of \$6,000. The new equipment will be depreciated by the straight-line method over a four-year life with a salvage value of \$25,000. Management estimates that investing in this machine will increase annual net after-tax cash flows by \$70,000 (which includes the tax shield effect of depreciation). Calculate the net present value for the investment opportunity, assuming a 40% income tax rate and an 8% hurdle rate.*

Ans : 64955
Explanation given : The NPV for the investment opportunity:

Calculator steps: Clear All

• Enter 4 in the N key
• Enter 8 in the I/YR key
• Enter 70,000 in the PMT key
• Enter 31,000* in the FV key
• Compute PV → –254,635** is the present value solution.

Net present value = \$254,635 – (\$185,000 + \$6,000 – 1,320***) = \$64,955.

*Released working capital of \$6,000 + Salvage value of \$25,000 = \$31,000.

**The present value is negative because the calculator is indicating that \$254,635 current investment (outflow) is equal to all the future inflows (positive payments), assuming an 8% discount rate.

*** After-tax cash on the sale of the old machine at Time 0 = \$2,200 × (1 – 40%) = \$1,320.

My question is why salvage value hasnt taken tax effect of 40 %?

• #### 2.  RE: Capital Budgeting : Salvage Value

Posted 12 days ago
If you mean the salvage value of the new machine, \$25000 , if has no gain over the salvage value.From capital gaintax point of view,  there is no tax effect at the end of useful life. Only cashflow of \$25000 with discounted value. In other way, there is  no tax benefit taken on the salvage value since this portion is not part of depreciation claim.
Hope understood,
Amitabha

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AMITABHA CHAUDHURI
Corporate Officer
MUMBAI MH
India
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• #### 3.  RE: Capital Budgeting : Salvage Value

Posted 11 days ago
Hi Amitabha,

This is what I was asking. Thanks

Kirti