CMA Study Group

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  • 1.  Capital Budgeting : Salvage Value

    Posted 09-12-2021 12:27 AM
    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 09-13-2021 01:34 AM
    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,

    Corporate Officer

  • 3.  RE: Capital Budgeting : Salvage Value

    Posted 09-13-2021 11:50 PM
    Hi Amitabha,

    This is what I was asking. Thanks