A proposed cost-saving device has an installed cost of $680,000. The device will

Question

A proposed cost-saving device has an installed cost of $680,000. 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 $50,000, 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 $75,000. What level of pretax cost savings do we require for this project to be profitable? MACRS schedule (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.) Pretax cost savings

Explanation / Answer

Answer: Pretax cost savings : $ 183,640.

Workings:

Initial Investment = Installed Cost of Device + Additional Working Capital = $ 680,000 + $ 50,000 = $ 730,000

Present value of depreciation tax shield:

Terminal cash flows = Working Capital Release + After tax Salvage Value = $ 50,000 + $ 75,000 x 0.65 = $ 98,750.

Let the cost savings per year be S.

Minimum acceptable S would be at the level where NPV = 0.

S x 0.65 x 3.88965 + 201,529 + 98,750 x 0.64993 - 730,000 = 0

or 2.52827S = 730,000 - 201,529 - 64,181

or S = $ 183,639.41

Year 1 Year 2 Year 3 Year 4 Year 5 Annual Depreciation 226,644 302,260 100,708 50,388 0 Tax Rate 0.35 0.35 0.35 0.35 0.35 Cash flows from depreciation 79,325 105,791 35,248 17,636 0 PV factor at 9% 0.91743 0.84168 0.77218 0.70843 0.64993 3.88965 Present Value of Depreciation Tax Shield 72,775 89,042 27,218 12,494 0 201,529

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