A proposed cost-saving device has an installed cost of $650,000. The device will
ID: 2731088 • Letter: A
Question
A proposed cost-saving device has an installed cost of $650,000. The device will be used in a five-year project but is classified as three-year MACRS (MACRS Table) property for tax purposes. The required initial net working capital investment is $46,500, the marginal tax rate is 30 percent, and the project discount rate is 15 percent. The device has an estimated Year 5 salvage value of $71,500. Required: What level of pretax cost savings do we require for this project to be profitable? (Do not round intermediate calculations. Round your answer to 2 decimal places (e.g.,32.16).)
Explanation / Answer
To find the initial pretax cost savings necessary to buy the new machine, we should use the tax shield approach to find the OCF
MACRS depreciation schedule.
The yearly depreciation :
Depreciation year 1= $650,000(0.3333) = $216,645
Depreciation year 2= $650,000(0.4445) = $288,925
Depreciation year 3= $650,000(0.1481) = $96,265
Depreciation year 4= $650,000(0.0741) = $48,165
Using the tax shield approach, the OCF ( Operating Cash flow) each year is:
OCF1= (S – C)(1 – 0.30) + 0.30($216,645)
OCF2= (S – C)(1 – 0.30) + 0.30($288,925)
OCF3= (S – C)(1 – 0.30) + 0.30($96,265)
OCF4= (S – C)(1 – 0.30) + 0.30($48,165)
OCF5= (S – C)(1 – 0.30)
Now we need the after tax salvage value of the equipment.
The after tax salvage value is:
After tax salvage value = $71,500(1 – 0.30) = $50,050
To calculate the necessary cost reduction, we would require a zero NPV.
The equation for the NPV of the project is:
NPV = 0 = –$650,000 – 46,500 + (S – C)(0.70)(PVIFA15%,5) + 0.30($216,645.00/1.15+ $288,925.00/1.152+ $96,265.00/1.153+ $48,165.00/1.154) + ($46,500 + 50,050)/1.155
NPV = 0=-$696,500 + [S-C (0.70) ( 3.35216 ) ]+ 149,307] +48,002
NPV = 0= [S-C (0.70) ( 3.35216 ) ] +$499,190.57
[S-C (0.70) ( 3.35216 ) ]= $499,190.57
(S-C) =$499,190.57/ 2.346512
(S – C) = $212,737.59