A proposed cost-saving device has an installed cost of $650,000. The device will
ID: 2775951 • 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 property for tax purposes. The required initial net working capital investment is $47,000, the marginal tax rate is 35 percent, and the project discount rate is 9 percent. The device has an estimated Year 5 salvage value of $72,000. What level of pretax cost savings do we require for this project to be profitable?
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 property for tax purposes. The required initial net working capital investment is $47,000, the marginal tax rate is 35 percent, and the project discount rate is 9 percent. The device has an estimated Year 5 salvage value of $72,000. What level of pretax cost savings do we require for this project to be profitable?
Explanation / Answer
MACRS depreciation
Depreciation = cost of asset x MACRS depreciation rate
D1 = $650,000(0.3330) = $216450
D2 = $650,000(0.4440) = $288600
D3 = $650,000(0.1480) = $96200
D4 = $650,000(0.0740) = $45,500
Tax Shield = Depreciation x tax rate
TS 1 = $216450 x 0.35 =75757.50
TS2 = $288600 x 0.35 =101010
TS 3= $96200 x 0.35 = 33,670
TS 4 = $45,500 x0.35 =15,925
After tax salvage value = Salvage value - (salvage value – book value) x tax rate
= 72,000 –(72,000-0)x0.35
=46800
PV of depreciation tax shield=
Year
Tax shield
PV factor 9%
PV
1
75757.5
0.9174
69502.29
2
101010
0.8417
85018.1
3
33670
0.7722
25999.42
4
15925
0.7084
11281.67
191801.5
PV of salvage value = 46800/ (1+0.09)^5
=30,416.79
PV of working capital recovered =47,000/ (1+0.09)^5
=30,546.78
PV of annuity factor PVIFA(5,9%) = 3.88965
Let the after cost savings per Annam be be CS.
NPV = Initial outflow + Pv of CS + PV of salvage value + PV of working capital
CS = 636036.43/ 3.88965
CS= 163,520.22
Before tax Cost saving = after tax cost savings / (1- tax rate)
= 163,520.22/ (1-0.35)
= 251,569.57
Pretax cost saving required is 251,569.57.
Year
Tax shield
PV factor 9%
PV
1
75757.5
0.9174
69502.29
2
101010
0.8417
85018.1
3
33670
0.7722
25999.42
4
15925
0.7084
11281.67
191801.5