Cost Management: A Strategic Emphasis 5th Edition by David Stout, Edward Blocher, Gary Cokins

Exercise 67

Machine Replacement with Tax Considerations A computer chip manufacturer spent $2,500,000 to develop a special-purpose molding machine. The machine has been used for one year, and will be obsolete after an additional three years. The company uses straight-line (SL) depreciation for this machine.

At the beginning of the second year, a machine salesperson offers a new, vastly more efficient machine. It will cost $2,000,000, will reduce annual cash manufacturing costs from $1,800,000 to $1,000,000, and will have zero disposal value at the end of three years. Management has decided to use the double-declining-balance depreciation method for tax purposes for this machine if purchased. (Note: make sure to switch to SL depreciation in year 3 to ensure that the entire cost is written off. You may find it useful to use the VDB function in Excel to calculate depreciation charges.)

The old machine’s salvage value is $300,000 now, and will be $50,000 three years from now; however, no salvage value is provided in calculating straight-line depreciation for tax purposes. The firm’s income tax rate is 45 percent. The firm desires to earn a minimum after-tax rate of return of 8 percent.

Required Using the net present value (NPV) technique, show whether the firm should purchase the new machine.

Step 1 of 4

Capital Budgeting is a process used to evaluate the various available projects to decide which project is to be proceeded with. First of all, we start process of capital budgeting with forecasting of future inflows and outflows of available projects. It is determined that what effect will it make on cash flows of the firm, and then NPV of project is calculated to determine how it would affect the value of firm. Net Present Value (NPV) means difference between present value of all inflows resulting from project and present value of outflows resulting from such project.