Eastern Inc.purchases a machine for $70,000.This machine qualifies as a five-year recovery asset under MACRS with the fixed depreciation percentages as follows: year 1 = 20.00%;year 2 = 32.00%;year 3 = 19.20%;year 4 = 11.52%.The firm has a tax rate of 40%.If the machine is sold at the end of two years for $50,000,what is the cash flow from disposal?

Question

Quizplus · Accepted Answer

We can use the MACRS depreciation percentages to calculate the book value of the machine at the end of year 2:

Year 1 depreciation: $70,000 x 20.00% = $14,000
Year 2 depreciation: $70,000 x 32.00% = $22,400
Accumulated depreciation: $14,000 + $22,400 = $36,400
Book value: $70,000 - $36,400 = $33,600

Since the machine is sold for $50,000, we have a gain on disposal:

Selling price: $50,000
Book value: $33,600
Gain on disposal: $16,400

However, we also need to factor in the tax implications of the sale. The gain on disposal is taxable at the firm's tax rate of 40%, so the after-tax gain is:

After-tax gain: $16,400 x (1 - 0.40) = $9,840

Therefore, the cash flow from disposal is the selling price minus the taxes paid on the gain:

Cash flow from disposal: $50,000 - $9,840 = $40,160

However, we need to consider the tax savings from the depreciation deductions taken in years 1 and 2. These savings reduce the net cost of the machine, which increases the after-tax cash flow from disposal. The total depreciation deductions for years 1 and 2 are:

Year 1 depreciation: $14,000
Year 2 depreciation: $22,400
Total depreciation: $14,000 + $22,400 = $36,400

The tax savings are equal to the depreciation deductions multiplied by the tax rate, so the total tax savings are:

Total tax savings: $36,400 x 0.40 = $14,560

Adding the tax savings to the after-tax gain gives us the total after-tax cash flow from disposal:

Total after-tax cash flow from disposal: $9,840 + $14,560 = $24,400

Therefore, the best choice is B, $43,440. This answer is incorrect because it does not take into account the tax savings from the depreciation deductions.