16. CSO: 2E1b LOS: 2E1b
Bison Inc. is considering the purchase of a new automatic machine to replace its current old fashioned machine. Bison's effective tax rate is 40%, and its cost of capital is 8%. Data regarding
the existing and new machines are presented below.
Existing New
Machine Machine
Original cost $100,000 $180,000
Installation costs 0 25,000
Freight and insurance 0 9,000
Expected end salvage value 0 14,000
Depreciation method straight-line straight-line
Expected useful life 10 years 5 years
The existing machine has been in service for five years and could be sold currently for $30,000.
Bison expects to save annual pre-tax labor costs of $50,000 from the new machine.
If the new machine is purchased, the incremental cash flows for the second year would be
a. $18,000.
b. $30,000.
c. $34,000.
d. $38,000.
Correct answer b. Bison's second year incremental cash flow is $34,000 as shown below.
After-tax cash savings $50,000 x .6 = $30,000
Tax shield/new equipment ($180,000+25,000+9,000-14,000) ÷ 5 x .4 = 8,000
- Loss of old tax shield - ($100,000 ÷ 10) x .4 = - 4,000
Incremental Cash flow $34,000
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. Vikesh
Analyst
Udupi
India
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